a foundation in business accounting

A FOUNDATION IN BUSINESS ACCOUNTING

A Foundation in Business Accounting

A. A. Callam, ACIS

Senior Lecturer Kingston Polytechnic

and

M. J. Ryder, ACA

Senior Lecturer, Kingston Polytechnic

©A. A. Callam and M. J. Ryder 1977

All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any

means, without permission

First published 1977 by THE MACMILLAN PRESS LTD

London and Basing/toke Associated companies in New York Dublin

Melbourne Johannesburg and Delhi

The paperback edition of this book is sold subject to the Net Book Agreement

The paperback edition of this book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, re-sold, hired out, or otherwise circulated without the publisher's prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser.

ISBN 978-0-333-18452-3 ISBN 978-1-349-02640-1 (eBook)DOI 10.1007/978-1-349-02640-1

Contents

Preface vii

1 The Role of Accountancy in Business 1

2 Methods of Data Recording 29

3 Summarising the Collected Data so 4 Financial Control 80

s Incomplete Records 102

6 The Partnership 124

7 Long-Term Finance: Share Capital and Debentures 144

8 Capital Structure and Valuation 169

9 Reconstructions, Amalgamations and Consolidations of 190 Company Accounts

10 Budgetary Control 224

11 Accounting for Costs 251

12 Standard Costing 291

13 Marginal Costing 315

14 Published Accounts of Limited Companies 329

15 Interpretation of Accounts 362

Appendix: Flow Charts and Diagrams 387

Index 401

Preface

Accountancy education has made considerable progress over recent years and the emphasis has moved from 'how?' to 'why?'. In this text we have attempted to combine the theory with the practical in order to give not only a mechanical ability but a fuller appreciation of the whole subject. In order to achieve this we have been selective in the topics we discuss, concentrating on those which we feel are fundamental to the understanding of the subject as a whole. Where possible we have used an example which continues stage by stage through a topic and have attempted to use a layout which would show as simply as possible the technique or problem being illustrated. Throughout the text we have emphasised the effect on the flow of funds through the business and not merely the effect of profits.

The text is specifically intended for students of accountancy at undergraduate level and students of accountancy foundation courses or similar professional examinations. It will also be useful for those who have a basic understanding of the subject but who wish to improve their knowledge of the theory and ability in the practical application. At the end of each chapter are graded questions which bring out the main points of a topic without including extraneous matters liable to cause confusion.

The chapters fall into seven main areas of study. Chapters 1-5 introduce accounting techniques and their effects on the balance sheet and income statement. Chapter 6 introduces the law and accounting requirements for partnerships. Chapters 7-9 cover accounting for limited companies. Particular problems of capital gearing and share valuations are highlighted. Amalgamations lead to consolidated accounts and these have been set out in a way which, it is hoped, will clarify this difficult topic. Chapters I 0-13 cover budgetary control and costing viewed as an integral part of business management, and emphasis is given to the relationship of the individual parts of the operation to the whole company plan. Chapter 14 covers the legal and professional standards required for company accounts, incorporating the treatment of taxation. Chapter 15 looks at the interpretation of accounts with a view to understanding the purpose of and not merely the ability to calculate ratios. Finally the Appendix includes various diagrams and charts to illustrate topics covered by the text and business information systems.

Preface viii

Our thanks are extended to Cadbury Schweppes Ltd and Rediffusion Ltd for their advice and assistance on current industrial accounting techniques; to our colleague, J. Lewis Brown, MSc, FCMA, for his reading of, and comments on, the script; and to Mrs Elizabeth Johnson and Mrs Sybil Austin for the typing.

Kingston on Thames, 1977 A.A. C. M.J.R.

CHAPTER 1

The Role of Accountancy in Business

Every business operation and most wealthy individuals have found it necessary to record in some way a measure of their wealth. In earlier times the wealth would have been measured in a convenient unit such as 'heads of cattle' or 'area of land'. Eventually the means of measurement became currency. With the need to record wealth and the establishment of a standard unit of measurement a system of accounting became necessary.

Accountancy incorporates four major function areas: (I) communication; (2) measurement; (3) control; and (4) decision-making.

Communication

Accountancy as a means of communication involves the submission of reports, written or verbal, to various bodies. The external report is made to those who have an interest in the business operation but who have no hand in its management. This includes such diverse interests as tax collectors and shareholders, as well as the owners of the business. In recent years considerable controversy has arisen as to how much information should be given to those external interests. Since 1830 governments have passed legislation to force limited companies to disclose certain information to their shareholders. However, events have shown that the kind of information provided may not be of much help to the user. Similarly employees and unions have suggested that they should be given information concerning future employment prospects and the company's trading intentions. Also certain sections of the community have suggested that society as a whole should be aware of the way in which companies use cheap labour abroad or are responsible for pollution.

To express the above in financial terms may not be possible but the fact that a business may be accountable for these matters could well force accountancy into the area of having to give reports on them.

Within an organisation it is necessary to report on the way the business is functioning and this is often done through the use of internal reports. Once company objectives have been established they are measured against actual results and any variance reported, in order that decisions and corrective action may be taken.

2 A Foundation in Business Accounting

The need for internal reports arises as a result of the increase in the size of the organisation and the necessity for management to be kept informed when they are not controlling routine matters. Another type of internal report is the budget based on the company objectives. This is prepared after detailed discussions and investigations within those areas which will determine the size and type of operation to be undertaken, e.g. market trends, production capacity and availability of finance.

When a business intends to start a new product line or acquire new plant and machinery it may commission a special report to analyse the potential of the project, to compare it with alternatives and to recommend a course of action to the management. These reports would not only look merely at the immediate profit but would consider implications in other areas such as possible overmanning and labour disputes.

Using reports as a means of communication involves an accountant not only in the task of collecting and recording data but in making value judgement in using the information; it is this latter area in which the student will need to use all forms of information and will require an interpretative capacity to be successful.

Accountancy is a much larger area than accounts if these are merely the means of recording data. It is, however, necessary to fully understand the system of data recording in order to appreciate exactly what the results indicate. Even more important, it will help in the understanding of what the system and results do not purport to do.

Measurement

At first, accountancy through the use of accounts acted as a measure of wealth based on the original cost of an object. Later it developed into measuring efficiency of operation and performance.

The means of measurement is the standard unit of currency and provided that the unit of currency remains constant changes in wealth can be easily measured. The method of measurement has tended to involve two distinct parts - the money invested in the business (capital) and the money generated through a trading operation (revenue). For many years accountants and lawyers have debated the difference and definitions of capital and revenue. Generally speaking taxation was levied on revenue (a recurring item) and not on capital.

In order to establish accuracy of measurement, detailed accounts are kept in the form of ledgers. Every transaction is recorded and analysed into convenient categories.

The existing method of data recording can be traced back to Italy in the thirteenth century and, in particular, to the great trading areas of Florence, Venice and Genoa. The terms 'debit' and 'credit', which will be explained in Chapter 2, can be traced back to this period. Luca Pacioli (c.l445-1515) first wrote about the system of double-entry book-keeping in 1494. Since that time many texts have expanded the system and added to the techniques. Until recent years many believed that accountancy and book-keeping were synonymous.

The Role of Accountancy in Business 3

In the past few years one of the basic requirements of this system of data recording has become less certain, namely that the unit of measurement remains constant. Inflation has until recently been relatively slow; however in the past few years this has not been the case and, as a result, the unit of measurement has itself been changing in real value. Thus by continuing to use a variable unit of measurement, changes in wealth cannot be easily isolated from the changes in the unit of measurement. There are at present several systems of reviewing this change caused by inflation, some more fundamental to book-keeping than others. It is not our intention to discuss these in detail but whichever system is used will mean that the accountancy profession will have to consider much more the fundamental purpose of the subject and not merely the mechanics of how to record it.

Control

One aspect of accountancy which is again based on the historic development of the subject is its use as a means of control. Where a business has its operation spread over many sites, perhaps throughout the country, it uses accounts to record the value of such assets as stock which the branch ought to have. Similarly its accounting operation may be so divided that it requires special accounts to be created in order to control the total amount of the debtors or creditors. Depending on the type of business and its operation, the accountant in the firm will create these controls to suit the needs of the business.

One point that each of these accounts has in common is that they are based on the system of book-keeping.

When the first limited companies were created in 1830 for the collection of capital in order to build railways, it was necessary to protect the investment of the shareholders and the creditors. Shareholders were divorced from management and this was a trend which continued throughout the nineteenth and twentieth centuries. As a result of a procession of fraudulent transactions, causing loss of shareholders' and creditors' money, it became necessary to introduce legislation to protect the shareholders and creditors, and this was policed by an audit. Originally the auditor was one of the shareholders, but later, as the accounts and types of fraud became more complicated, it became necessary for those with a knowledge of accounts to become involved. Eventually the auditor became an independent agent on behalf of the shareholders.

The accountancy profession developed into two basic streams, that of the auditing profession and that of those who work within industry and commerce. The professional accounting bodies have, since their inception in the nineteenth century, tried to regulate the standards of their members and act as advisers to government in the formulation of requirements. In recent years, through the Statements of Standard Accounting Practice, they have set standards which regulate the way information is given to shareholders.

Accountancy as a means of control is thus exercised by the creation of book-keeping records and legislation and by the standing of the professional body to act as independent witness and carry out an audit function.


The following statements are typical reports by auditors indicating their attempts to control the accuracy of information presented to shareholders. Statements 2, 3 and 4 contain reservations ort certain matters in the accounts and are known as qualified audit reports.

(1) In our opinion, the accounts set out on pages ... to ... give a true and fair view of the state of the company's affairs at ... and of its profit (or loss) for the year ended on that date and comply with the Companies Act 1948 and 1967.

Signed ........... . (2) We have examined the accounts of ... Ltd and in the absence of

adequate analysis of factory wages we are unable to verify the charge for labour and overhead amounting to £ ... included in the additions of£ ... to plant and machinery during the year.

Subject to the foregoing reservations the accounts set out on pages ... to ... in our opinion give a true and fair view of the state of the company's affairs at ... and of its profits for the year ended on that date and comply with the Companies Act 1948 and 1967.

Signed ........... . (3) We have examined the accounts set out on pages ... to ... and find

that certain stocks valued at £ ... in the account are located in ... and are at present unrealisable because they appear to have been sequestered by the government of that company. It is uncertain whether they will be realisable by the company at the amounts stated, if at all, and for this reason we are unable to form an opinion whether the accounts give a true and fair view of the company's affairs at ... and of its loss for the year ended on that date.

In all other respects the accounts comply with the Companies Act 1948 and 1967

Signed ........... . (4) We have examined the accounts set out on pages ... to ... and found

that the shares in P.Q. Ltd, which is in liquidation, are shown in the Balance Sheet at a cost of £ .... The liquidator has stated that it is unlikely that the company will be able to pay its debts in full. For this reason the accounts, in our opinion, do not give a true and fair view of the state of the company's affairs at ... and of its profit for the year ended on that date.

Signed ........... .

Decision-making

As a result of activities information is communicated on a basis of a standardiset system of measurement and results in information which can be relied on when making decisions.

Decisions of management can be improved by a system of reporting only the exceptions from known objectives. These reports will include figures, not as an end in themselves but merely to quantify a problem area to show its relative significance. Similarly shareholders are given information on which to base their investment decisions. These reports will include the annual audited accounts and also statements by the chairman and directors.


Creditors may use published accounting information to decide whether or not to advance goods on credit and the extent of the credit.

Although accountancy has in the past been used to report historic events, the tendency in recent years has been to develop the subject into forecasting a more dynamic area of activity. It will be necessary, however, to look in detail at the basic system of accountancy and in particular at the book-keeping system, remembering at all times the purpose for which the data are being recorded (see figure 1.1).

1 __ Audit function

Figure 1.1

Consultancy and advice, e.g. Tax planning

Consultancy and

advice

Financial-----Accountancy------Management I I

Industrial situation Industrial situation

I I Interested in Interested in

A. A. Cost ascertainment

Financial matters - - - - - - - - -B. Profit

i. Creditors/debtors ii. Wages

iii. Cash flow L _ iv. Preparation of _ _ _j

final accounts

The Business

C. Efficiency

The first basic concept on which accountancy is based is that a business is treated as being completely separate from the owner or proprietor, even if the business is completely owned by the proprietor.

When a business is started by the proprietor investing his private funds in it, these funds become the funds of the business and an accounting system is then necessary to indicate to the proprietor the manner in which they have been used and how additional funds have been obtained. To express the matter in another way, the funds invested by the proprietor represent his interest in the business and the accounting system indicates the return earned for the proprietor on his investment by way of profit arising from certain transactions.


'Funds' is a term used in accountancy to mean any source offmance. There are several sources of funds available to a proprietor of a business or a person about to start a business: (1) the personal resources, cash or assets he already possesses; (2) a sympathetic bank manager who will give him a loan or overdraft; (3) suppliers who are willing to give him a period of credit before asking him for payment; (4) profit generated by selling goods or services at a price greater than the total cost of providing those goods or services.

Once the funds have been invested in the business they will change their form many times. For example, a business may commence with cash, which is then used to buy stock of goods which in turn are sold, producing cash again. The sale of stock at a price greater than the original cost will result in an increase in the business assets, specifically cash. With these increased assets it is now possible to purchase a greater quantity of stock, or other assets. In this way the business expands without the proprietor having to introduce additional capital:

Cash £10,000 t

Sales £10,000 t

Cash £5 ,000-----+ Stock £5,000

1 Stock £7,000 +-----Cash £7,000 +----Sales £7,000

After four transactions, two purchases and two sales, the cash resources have increased 100%. If any part of the cash after the first sale had been utilised for the purchase of a motor vehicle for use in the business and not for resale, subsequent growth would have been limited to the profit earned on a smaller stock:

Cash £4,200 t

Sale £4,200 t

Cash £5 ,000---~ Stock £5,000

1 Stock £3,000 +---Cash £7,000 +----Sale £7,000

,j. Motor Vehicle £4,000

The business has earned £3,200 in profit after two sales but cash resources have decreased by £800 from the original balance as a result of investing the profit in the business.

It is this continual turnover and utilisation of the funds of a business which give rise to the need for accounting records.

'A' decides to start a small business trading in electrical goods and has the following assets which he intends to use in the firm:

Cash in Hand Cash at the Bank

200 4,000

£4,200


£4,200 represents his interest in the business. If 'A' loses any of the cash his interest will be reduced by the same amount. This can be explained by the equation

Proprietor's Interest = Net Assets

This is a fundamental of accountancy, and even though at later stages greater analysis is given to each side of the equation, its root is the same. The equat .. m is normally expressed numerically and the previous example would be written as follows:

Net Assets: Cash at Bank Cash in Hand

Proprietor's Interest: Original Capital

4,000 200

£4,200

£4,200

Thi

s st

atem

ent

disp

laye

d is

know

n as

a B

alan

ce S

heet

and

is o

ne o

f the

bes

tkn

own

acco

unti

ng s

tate

men

ts.

The

eff

ect

on t

he p

ropr

ieto

rs's

inte

rest

sho

uld

be

cons

ider

ed a

s a

resu

lt o

f th

e fo

llow

ing

tran

sact

ions

:

The

bus

ines

s bu

ys

raw

mat

eria

ls a

nd

pays

£50

0 by

che

que

for

them

. T

he p

ay

men

t ou

t o

f th

e ba

nk a

nd t

he p

ur

chas

e o

f st

ock

does

no

t af

fect

the

tot

al

asse

ts o

f th

e bu

sin

ess,

it

mer

ely

con

vert

s one

ass

et, c

ash,

in

to a

noth

er, s

tock

.

II

A p

iece

of

mac

hin

ery

is pu

rcha

sed

at a

cos

t of£

1,0

00

and

is pa

id f

or b

y ch

eque

. The

pur

ch

ase

of

mac

hin

ery

is e

xact

ly t

he

sam

e ty

pe o

f tra

nsa

ctio

n as

the

pur

ch

ase

of s

tock

and

do

es n

ot a

ffec

t th

e to

tal

asse

ts.

The

on

ly d

iffe

renc

e is

th

e fu

ture

use

. The

m

achi

nery

will

be

reta

ined

for

an

in

defi

nite

per

iod

whi

le t

he s

tock

will

be

sol

d in

the

im

med

iate

fut

ure.

III

The

pro

prie

tor

wit

hdr

aws

£50

of

cash

fr

om t

he b

usin

ess

for

his

own

pers

onal

us

e. T

he w

ithd

raw

al

of

cash

fro

m t

he

busi

ness

by

the

pro

prie

tor

is a

red

uc

tion

in t

he a

sset

s o

f th

e fi

rm a

s no

oth

er

asse

ts w

ere

acqu

ired

to

rep

lace

it.

The

pr

opri

etor

's in

tere

st

in th

e bu

sine

ss is

th

eref

ore

sim

ilarl

y re

duce

d fr

om t

he

orig

inal

£4,

200

he

inve

sted

to

£4,1

5 0

whi

ch r

emai

ns. T

his

type

of

tran

sact

ion

is d

escr

ibed

as

Dra

w

ings

and

ref

ers

to

the

rem

oval

fro

m

the

busi

ness

of a

sset

s ta

ken

by t

he p

ro

prie

tor

for

his

pers

ona

l us

e.

IV

Hav

ing

mad

e so

me

good

s fr

om h

alf

the

raw

mat

eria

l st

ock

purc

hase

d, th

ese

are

sold

for

£60

0 ca

sh.

The

sal

e o

f th

e st

ock

for

cash

has

tw

o ef

fect

s on

the

as

sets

of

the

busi

ne

ss (

a) t

he s

tock

is

redu

ced

by h

alf

to

£250

, sin

ce t

hat

amou

nt le

ft th

e bu

si

ness

: (b

) th

e ca

sh i

n ha

nd is

inc

reas

ed

by £

600,

the

pro

ceed

s o

f th

e sa

le o

f st

ock.

The

ass

ets

of

the

busi

ness

hav

e th

eref

ore

rise

n by

an

inco

me

of £

600

-ou

tgoi

ngs

£250

=

neti

ncre

ase£

350.

A

sim

ilar

incr

ease

in

the

prop

riet

or's

in

tere

st m

ust

also

ta

ke p

lace

, rep

re

sent

ed b

y th

e in

cr

ease

ari

sing

fro

m

the

trad

ing

tran

sa

ctio

ns. S

uch

in

crea

ses

are

term

ed

'Pro

fits

'.

v T

he c

ash

in h

and

is r

educ

ed t

o £2

5,

£725

bei

ng p

aid

into

the

ban

k. T

he

tran

sfer

fro

m c

ash

in h

and

to t

he b

ank

has

no e

ffec

t on

the

tota

l as

sets

of t

he

busi

ness

and

lik

e th

e fi

rst

tran

sact

ions

is

only

an

exch

ange

of

one

asse

t for

ano

ther

. T

he B

alan

ce S

heet

af

ter

each

of

the

tran

sact

ions

wou

ld

appe

ar a

s di

spla

yed.

Co A 6J ;;::

;::

2- ..... c::·

;:: :::· ~ "' ;::· ~ A

r, 8 ;;::

;:: .....

~·

Bal

ance

She

et o

f 'A

'

Ori

gina

l (I

) (I

I)

(III

) (I

V)

(V)

Equ

ipm

ent

--

1,00

0 1,

000

1,00

0 1,

000

Cas

h at

Ban

k 4,

000

3,50

0 2,

500

2,50

0 2,

500

3,22

5

Cas

h in

Han

d 20

0 20

0 20

0 15

0 75

0 25

S

tock

-

500

500

500

250

250

--

--

--

--

--

--

Net

Ass

ets

£4,2

00

£4,2

00

£4,2

00

£4,1

50

£4,5

00

£4,5

00

~

--

--

--

--

Pro

prie

tor'

s In

tere

st

"" C

apit

al

4,20

0 4,

200

4,20

0 4,

200

4,20

0 4,

200

::0

0 P

rofi

ts

--

350

350

~

--

--

--

~

4,20

0 4,

550

4,55

0

Les

s F

unds

Wit

hdra

wn

50

50

50

:t:..

--

--

--

--

--

--

~

£4,2

00

£4,2

00

£4,2

00

£4,1

50

£4,5

00

£4,5

00

8 :::: ::: ..... "" ::: ~ s· t:x:l

:::: "' s· ~ '0


From these transactions certain fundamental statements can be made:

(I) When a business is started it is treated completely separately from the proprietor's personal assets and his interest in the business equals exactly the assets of that business.

(2) Where funds leave the business but are replaced by other assets of an equal value, the total assets will remain the same as will the proprietor's interest. However, where they are replaced by an asset of a different value then a change will occur in the proprietor's interest. If replaced by an asset of greater value the proprietor's interest is increased. Where an asset is replaced by one of smaller value the proprietor's interest is reduced.

(3) Where assets are withdrawn from the business, often known as an outflow of funds from the business, and not replaced by' other assets then a reduction will occur in the proprietor's interest.

'B' decided to start a business trading in office equipment and acquired premises, paid for from his own money, for £8,000. He spent a further £1,500 on fixtures and fittings for the premises and put £100 of cash into the till on the first day of trading. The following transactions took place (see displayed Balance Sheet of 'B'):

A debtor is someone who owes the business money. A creditor is someone to whom money is owed by the business. The effect of the transactions is now considered but first it should be under·

stood that:

(1) A creditor is a liability or negative asset, as it is a legally enforceable promise to pay cash from the assets of the business in exchange for goods or services received.

(2) A debtor is an asset of the business, as this is a legally enforceable claim by the business on the assets of the person or firm to whom the goods were sold.

Creditors for goods or services are often described as liabilities; other liabilities would include amounts owing by the business for taxation, loans from people other than the proprietor and, in the case of a limited company, dividends due to be paid to shareholders. The creation of liabilities also gives rise to third parties with interests in the business funds, in addition to the proprietor.

The Balance Sheet illustrated also shows one of the usual business problems, that of being unable to pay the creditors until funds have been obtained from the debtors. This may in some circumstances lead to difficulties, as creditors may not be prepared to supply further goods until previous deliveries are paid for. Funds must therefore be obtained from other sources such as bank overdrafts. It will also be seen that although the proprietor has earned £1 ,000 profit he is not able to withdraw his profit from the business due to the lack of cash.

Examination of the two examples shown will give an indication of the considerable movement in the assets and liabilities of a business, even though very few

II

III

IV

v T

he b

usin

ess b

ough

t,

25%

of

the

stoc

k T

he d

ebto

r pa

id h

im

The

sup

plie

r w

as

'B' w

ithd

rew

£50

of

on c

redi

t, s

tock

for

w

as s

old

on c

redi

t £8

50 b

y ch

eque

. pa

id £

700

by

cash

for

per

sona

l £8

00. T

his

tran

sac-

term

s fo

r £1

200.

ch

eque

. The

set

tle-

expe

nses

. T

he w

ith-

tion

doe

s no

t al

ter

The

sal

e o

f 25

% o

f m

ent

by d

ebto

rs (

III)

dr

awal

of

cash

by

the

tota

l net

ass

ets

the

stoc

k gi

ves

rise

an

d o

f cr

edit

ors

(IV

) th

e pr

opri

etor

of

the

busi

ness

bu

t to

an

outf

low

of

by p

aym

ent

has

no

caus

es a

red

ucti

on

crea

tes

a lia

bilit

y in

as

sets

of £

200,

re-

effe

ct o

n th

e to

tal

in t

he a

sset

s an

d th

e fo

rm o

f a

plac

ed b

y an

inf

low

ne

t as

sets

of t

he

also

his

int

eres

t in

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transactions have taken place, and it is for this reason that a system of bookkeeping is necessary in order to control the day-to-day operations in view of the impossibility of preparing a Balance Sheet after each transaction to discover the changes in the state of the business.

Fixed Assets and Current Assets

It will have been observed that certain assets of the business were changed frequently as a result of trading operations. Such assets are referred to as 'Curre~t Assets'. Current assets include such items as stocks of raw materials, work in progress and fmished goods, debtors, cash in hand and bank balances. These assets are utilised on a day-to-day basis for the purpose of trading and generating profits.

The completion of the trading cycle below should result in an increase in the assets of the business which will be reflected by a similar increase in the proprietor's interest.

Assets not used for trading operations are referred to as 'Fixed Assets'. These would include land, buildings, plant and machinery, vehicles, investments and office fixtures and fittings. These assets, though used on a day-to-day basis, are not utilised for the purpose of trading and will only be sold when they are of no further use to the business.

In order to decide whether an asset should be classified as Current or Fixed it is necessary to know the trading operations of the business. For example, the manufacturer of motor vehicles will treat his stock of completed vehicles as a current asset, as these will be disposed of through trading. The vehicle used by the manufacturer for the delivery of completed stocks and spares will be treated as a fiXed asset because it is not intended for resale.

Liabilities

Amounts owed by the business to parties other than the proprietor are known as 'Liabilities', which are differentiated as 'Current Liabilities' or 'Long-Term Liabilities'.

Current liabilities arise as a result of normal trading activities and include creditors and bank overdrafts. In the case oflimited companies they also include Taxation and Proposed Dividends. Current liabilities are settled from the cash generated by sales.


CREDITORS

Payment fo' pu'ch'"'/ ~chase of stock on e<edit

STOCK CASH

Payment for sales ~ ~ofstockonc.edit DEBTORS

Long-term liabilities arise through the proprietor obtaining finance from other parties for the expansion of the business. The repayment of these liabilities is not required in the immediate future. This can be recognised by the fact that they carry a fixed rate of interest and are usually repayable on a fixed date.

Proprietor's Interest

The Proprietor's Interest is analysed between Capital and Retained Profits. The capital is the amount originally invested in the business together with additional funds subsequently placed in the business. Retained profits are the amount of the increase in the assets as a result of trading operations, less any funds withdrawn by the proprietor for his personal use.

The withdrawal of funds may also be from the capital and both these forms are described as drawings.

The equation stated earlier can now be expanded as follows:


Capital + Profits - Drawings

Analysis of Profit

Net Assets

Fixed Assets + Current Assets - liabilities

Having prepared a Balance Sheet the proprietor will know that profit has been earned as a result of trading operations, but he will not know the details of how such profit arose. These details will be supplied by means of an Income Statement analysing the figure of profit on the Balance Sheet.

The Income Statement will show details of sales, the cost of those sales and the expenses incurred in the running of the business.

In the Balance Sheet of 'B' a profit of £1 ,000 was shown as a result of selling goods which had cost £200. This apparent profit has taken no account of expenses which may have been incurred. These expenses would cover items such as delivery charges, administrative costs and other incidental expenses.


'C' started a business and the following transactions took place: (i) Purchase of stock for resale £2,000 (ii) Sold 80% of stock for £4,000 (iii) Paid expenses: wages £350

rent £400 advertising £250

It should be appreciated that these are isolated transactions. As the trader has not sold the whole of his stock he must have 20% remaining as an asset, the cost ofwhichmust be 20% of £2,000, i.e. £400. When preparing an Income Statement it is usual to calculate a 'Gross Profit' figure which is the difference between the cost of the goods sold and the revenue earned from those sales. The gross profit figure gives an indication of the efficiency of the trading function of the business and generally speaking should remain constant. The expenses of managing the business are then deducted from the gross profit to give a 'Net Profit', which is the increase these transactions have caused to the proprietor's interest. A similar increase will also have taken place with the assets of the business.

Income Statement of 'C'

Sales Less Purchases

Less remaining stock

Cost of goods sold

Gross Profit

Less Expenses:

Net Profit

Advertising Rent Wages

Accounting Conventions

2,000 400

250 400 350

4,000

1,600

2,400

1,000

£1,400

% 100

40

60

25

35

Over a period of time various accounting methods have evolved and these have been standardised by the accounting profession into particular conventions. This standardisation ensures that accounting information is presented in a manner that enables comparisons to be made between frnancial periods or businesses. These conventions attempt to eliminate differences arising as a result of differing methods of calculation having been used, and are referred to as: (1) matching 9r accrual; (2) consistency; (3) prudence or conservatism.


The Concept of Matching

This concept requires that revenue is matched against the cost of earning that revenue.

In the Income Statement of 'C' the revenue from sales (£4,000) was matched against costs of goods sold (£1 ,600), together with management expenses of £1,000.

The Concept of Consistency

This concept requires that the same methods are employed from one accounting period to another in order that the results obtained are comparable, and any changes are due to economic factors and not merely due to changes in methods of calculation. In the case of stock valuation, for example, the recognition of what constitutes costs in one financial period must be followed by similar considerations in subsequent periods.

The Concept of Prudence

This concept requires that revenue is taken into account only when there is a certainty that it has been earned. However, expenses should be accounted for as soon as the business becomes aware of them. The concept is primarily concerned with the adoption of a conservative attitude. Revenue from the sale of stock is only recognised when the property of the goods has passed to the buyer.

A business should not recognise profit before it is actually earned but provision must be made for all foreseeable losses.

These concepts are applied as follows. 'D' has been in business for a number of years; the Income Statement and Balance Sheet of the business appeared as follows:

Income Statement of 'D' Balance Sheet of 'D' Sales 7,500 Fixed Assets 5,450 Less Cost of Sales: Current Assets:

Opening Stock 1,700 Stock 1,500 Purchases 2,800 Debtors 1,250

Cash 300

4,500 3,050 Oosing Stock 1,500 Less Creditors 500

3,000 2,550

Gross Profit 4,500 £8,000

Less Expenses: General 1,375 Capital 6,775 Rent 900 Profit 1,225 Rates 1,000

3,275 --£1,225 £8,000


The charge of £900 rent covered a period of nine months from the beginning of the financial year and the charge of £1 ,000 rates covered a period of fifteen months from the beginning of the financial year.

The trader considered that his closing stock could be sold for £3,750 but he had no known customers.

In order to comply with the matching concept it will be necessary to adjust the charges for Rent and Rates so that a twelve-month charge is included in this accounting period of twelve months. The rent and rates are calculated as follows:

Rent Rates

mths. mths. Paid 900 9 Paid 1,000 15 Due 300 3 Less Not due 200 3

Income Statement £1,200 Income Statement £800

(1) The increase in the charge for rent creates an additional liability in respect of the period for which the premises were occupied but not paid for by the end of the accounting period. Such items are known as 'Accruals'.

(2) The reduction in the charge for rates creates an additional asset in respect of the period for which the premises have been paid for but not yet occupied. A claim for repayment could be made if the premises were vacated before the expiration of the three-month period. Such items are known as 'Prepayments'.

(3) In the absence of other information it can be assumed that the closing stock has been calculated in a manner consistent with the calculation of the opening stock.

(4) The trader's assumption that he will be able to sell his remaining stock has been ignored, as not to do so would be to anticipate profits which have not, and may in fact never, be earned. Even if customers were known the future sales would still be ignored because there could be a breakdown in the negotiations.


The redrafted Income Statement and Balance Sheet are as follows:

Income Statement Balance Sheet %

Sales 7,500 100 Fixed Assets 5,450 Less Cost of Sales: Current Assets:

Opening Stock 1,700 Stock 1,500 Purchases 2,800 Drs. 1,250

Rates 200

4,500 1,450 Less Closing Stock 1,500 Cash 300

3,000 40 3,250

Gross Profit 4,500 60 Less: Crs. 500 Rent 300

Less Expenses: General 1,375 800 Rent 1,200 Rates 800 2,450

3,375 45 £7,900

£1,125 15 Capital 6,775 Profit 1,125

£7,900

Effect on Profit of Stock Valuation

In order to obtain details of the stock level at the end of a financial period it is necessary that a physical verification be undertaken or that records of the stock movement be maintained. Having summarised the stock by product type, a valuation must then be placed upon each type of stock. This valuation is critical, since it will directly affect the gross profit as is shown in the following illustration.

It is essential when valuing stock that the concept of prudence be adopted, and for this reason the valuation would normally be the lower of cost or net realisable value. Net realisable value is the expected revenue on the sale of an item. Problems arise, however, as to whether stock is considered as a whole or whether the individual types are valued separately.


Stock type Cost Net Realisable value Lowest value w 1,000 2,000 1,000 X 3,000 5,000 3,000 y 2,500 500 500 z 5,000 9,000 5,000

£11,500 £16,500 £9,500

Income Statement

Sales 50,000 50,000 50,000 Less: Cost of Sales

Opening Stock 9,000 9,000 9,000 Purchases 31,000 31,000 31,000 -- --

40,000 40,000 40,000 Less Closing Stock 11,500 16,500 9,500

28,500 23,500 30,500

Gross Profit £21,500 £26,500 £19,500

If the stock is considered in total the most prudent value is that of cost (£11 ,500). However, if the individual items of stock are valued there may be items the resale value of which is lower than the original cost. In this case the net realisable value of the item will be adopted as in the case of item Y (£500). The adoption of the lower of cost or net realisable value for individual items will give the lowest and therefore more prudent valuation (£9,500).

The use of the cost method, whilst ensuring that no profit is taken until earned, does not ensure provision has been made for possible losses, as in the case of item Y. The use of the lower of cost or net realisable value does ensure that such losses are charged in the financial period in which incurred.

If the net realisable value is used this gives rise to a profit which has not yet been earned and in fact may not arise. The Income Statement would show an inflated value of profit matched by an inflated value of stock, and no additional funds would have been created. In a future accounting period, if the goods are sold at this price, no profit would be shown because the valuation of the opening stock, the closing stock of the previous period, would have the same value as the sales.

One of the problems of stock valuation is in determining exactly what constitutes cost. In a manufacturing business the cost of raw materials and productive labour is easily recognisable but should any recognition be taken of incidental charges such as transportation and handling, duties and taxes and the overheads of rent and rates, light and heat, among others?

The standard recommendation (SSAP9) is that cost constitutes:- original cost of purchase, carriage and storage, import duties and production overheads, whilst allowances consisting of trade discounts, rebates for bulk purchases and subsidies can be deducted.

No addition is to be made for selling, distribution or administration expense.


In order to prevent the proprietor withdrawing all the funds generated a charge is made in the Income Statement so that the cost of the original asset is apportioned over its estimated life. This charge is known as 'Depreciation.'

Depreciation is an attempt to arrive at the cost of using the fixed assets of the business by apportioning the original cost over the estimated life of the particular assets. An item of expense will appear in the Income Statement but the business has not incurred a cash outlay. This arose when the fixed asset was originally purchased. The charge for depreciation ensures that profits are retained in the business and not withdrawn by the proprietor.

The funds represented by the retained profit need not necessarily be in the form of cash but may be converted into other assets, such as investments, which can be realised when the necessity for replacement of the original asset arises. At the same time the management of the business has to understand that in times of inflation the cost of replacement will be greater than the original cost and additional funds will have to be set aside to meet this increased cost.

The following Balance Sheets illustrate the effect of withdrawing all profit as compared with retaining profits by way of depreciation.

Balance Sheets

I II III IV

Fixed Assets 5,000 5,000 5,000 5,000 Less Depreciation 1,000 1,000

5,000 5,000 4,000 4,000 Current Assets Cash 2,000 1,000

£7,000 £5,000 £4,000 £5,000

Capital 5,000 5,000 5,000 5,000 Profit 2,000 2,000 2,000 2,000 Less Depreciation 1,000 1,000

1,000 1,000 -- --7,000 6,000 6,000

Drawings 2,000 2,000 1,000

£7,000 £5,000 £4,000 £5,000

Original Balance Sheet All funds generated Available Drawings are by profits have funds withdrawn, made from been withdrawn ignoring the available and there are no fact that there profit which funds for the re- is only £1 ,000 therefore placement of of profit leaves funds Fixed Assets available after for the

Depreciation. replacement of Fixed Assets


P.W. had been in business for a number of years and the Balance Sheet appeared as follows:

Balance Sheet as at 1 January

Fixed Assets: Land and Buildings Plant and Machinery Motor Vehicles

Current Assets: Stock Debtors Cash at Bank

Less liabilities: Creditors

Capital Retained Profits

Cost 8,000 7,500 2,500

£I8,000

Depn. 8,000

I,300 6,200 I,900 600 --

£3,200 £I4,800

3,500 4,200 I,900

9,600 4,300

5,300

£20,IOO

IO,OOO IO,IOO

£20,IOO

An analysis of his Bank Statement at 3I December showed the following:

Receipts Received from Debtors Cash from Sales New Capital Introduced

3,600 25,000

3,000

£3I,600

Payments Paid to Creditors Purchases of Stock for cash Wages Advertising Stationery Sundry Expenses Drawings 9 mths. Rent from I Jan. I5 mths. Rates from I Jan.

£8,000 of stock still remained in the business. £9,000 of goods had been sold on credit. £4,500 of goods had been bought on credit.

2,000 I5,000 5,000 6,000

200 700

2,500 900 500

£32,800

Depreciation was to be provided for Plant and Machinery £750; Motor Vehicles £I 50.


See pages 22 and 23 for Balance Sheet.


Balance Sheet

II Original Balance After Receipts After Payments

Sheet

Fixed Assets Land and Buildings 8,000 8,000 8,000 Plant and Machinery 6,200 6,200 6,200 Motor Vehicles 600 600 600

14,800 14,800 14,800 Stock 3,500 3,500 3,500 Debtors 4,200 600 600 Prepayments Cash 1,900 33,500 700

9,600 37,600 4,800 Less: Creditors 4,300 4,300 2,300

Accruals

5,300 33,300 2,500 ---£20,100 £48,100 £17,300 --- --- ---

Capital 10,000 13,000 13,000 Profit retained 10,100 10,100 10,100

Income Statement Sales: Cash 25,000 25,000

Credit

25,000 25,000 Opening Stock Purchases: Cash 15,000

Credit

15,000 Closing Stock

Cost of sales 15,000

Gross profit 25,000 fO,OOO Expenses 6,000 Wages 5,000 Stationery 200 Sundry 700 Rent 900 Rates 500 Depreciation

13,300

Net profit 25,000 (3,300)

48,100 19,800 Less: DRAWINGS 2,500

£20,100 £48,100 £17,300 ---


III IV After Stock and After Accruals,

Credit Transactions Prepayments & Depreciation

Cost Depn. 8,000 8,000 8,000 6,200 7,500 2,050 5,450

600 2,500 2,050 450

14,800 18,000 4,100 13,900

8,000 8,000 9,600 9,600

100 700 700

18,300 18,400 6,800 6,800

300

11,500 7,100 11,300

£26,300 £25,200 --- ---

13,000 13,000 10,100 10,100

25,000 25,000 9,000 9,000

34,000 34,000 3,500 3,500

15,000 15,000 4,500 4,500

23,000 23,000 8,000 8,000

15,000 15,000

19,000 19,000 6,000 6,000 5,000 5,000

200 200 700 700 900 1,200 500 400

900

13,300 14,400

5,700 4,600

28,800 27,700 2,500 2,500

£26,300 £25,200 --- ---


(1) Balance Sheets I, II and III are intermediate stages only in arriving at the final position. They cannot be considered as a logical sequence of events. For example in Balance Sheet I £25,000 stock was sold but there is no corresponding purchases.

(2) The previous stock £3,500 is incorporated in the cost of sales calculation on the Income Statement and this stock has been sold. The closing stock £8,000 represents purchases not sold and therefore reduces the amount of total purchases and opening stock to the amount actually sold. It is also an asset and therefore will appear on the Balance Sheet.

(3) Adjustments in respect of accruals and prepayments for rent and rates and for depreciation have been made:

Rent

Paid 900 9 months Paid Accrual 300 3 months Prepayments

Income Statement £1,200 12 months

Summary

(1) The basic accounting equation is: Net Assets = Proprietor's Interest Fixed Assets + Current Assets - liabilities =

Capital + Profits - Drawings. Fixed Assets + Current Assets - liabilities =

Capital + Revenue - Expenses - Drawings Fixed Assets + Current Assets + Expenses + Drawings =

Capital + Revenue + liabilities

Rates

500 15 months 100 (3 months)

£400 12 months --

(2) The exchange of one asset for another of the same value will not create profits. However, if they are exchanged for an asset of a different value, profit or loss will result.

(3) The removal of assets by the proprietor for his personal use reduces the total assets and the proprietor's interest.

(4) The outflow of assets from a business which does not result in the acquisition of other assets creates expenses.

The above could be expressed in account form in the following manner:

Account

Fixed Assets Current Assets

Expenses Profit Withdrawn

Capital liabilities Revenue Profit Retained


Questions

1.1 State the effect of the following transactions on the assets, liabilities and capital:

(a) Proprietor introduces cash into business. (b) Business purchases fittings for cash. (c) Business purchases vehicles for cash (d) Rent is paid. (e) Stock purchased for cash. (f) Wages are paid. (g) Stock sold on credit. (h) A vehicle is sold for cash. (j) Additional stock is purchased on credit. (k) A further sale is made for cash. (l) Proprietor withdraws cash.

1.2. Give a definition for each of the following terms:

Current Assets Gross Profit Working Capital Fixed Assets Current liabilities Net Profit Proprietor's Interest.

1.3 John Smith owns a hardware business. The Balance Sheet at the beginning of the financial year showed the following position:

A B c D E F G Premises 2,000 Equipment 900 Van 700 Stock 1,550 Debtors 250 Bank 1,470 Cash 30

£6,900 Creditors 1,200

£5,700

Capital 5,700 Profit

£5,700


Show the Balance Sheet after each of the following transactions has occurred:

(a) Goods sold (Cash Sales £300, Credit Sales £100) which were included at cost in the stock at £280.

(b) Van expenses - Tax £25; oil £10; maintenance £5 - all paid by cheque.

(c) Drew cheques for £800 to pay the creditors. Paid £300 of the office cash into the bank.

(d) Sold van at book value for £700 cash and paid this amount into the bank immediately.

(e) Smith withdrew £50 from the bank for living expenses. (j) Cash £50 and cheques £200 received from debtors. (g) Sold office equipment valued in books at £40 for £70 cash.

1.4 Prepare a Balance Sheet from the following information taken from the books of John Jones at the end of his first year of trading on 31 March.

Cash at Bank Stock Freehold Premises Wages owing to staff Cash withdrawn from

business by proprietor

1,400 3,000 5,000

40

920

Amount owed by business Amount owed to business Cash in till Shop fittings Net profit for year

Note: You will have to calculate the original capital.

2,400 2,500

20 1,000 2,920

1.5 From an examination of the following Balance Sheets prepare a statement explaining how the bank balance was reduced in view of the profit earned in the period.

Premises Fittings Vehicles Stocks Debtors Bank

Creditors

1 Jan. 10,000 3,500 2,900

15,700 6,300 9,800

Net Assets

48,200 4,300

£43,900

31 Dec.

15,800 5,600 3,500

18,900 6,300

900

51,000 4,300

£46,700

Do you consider that the proprietor can withdraw all the profits earned?


1.6 Arrange the following information, given at 31 December, into two columns: (1) assets, drawings, expenses and (2) liabilities, capital, revenue.

Goods sold for cash 39,000 Goods sold for credit 35,000 Opening stock plus purchases 70,200 Wages 7,100 Electricity 300 Vehicle running expenses 800 Administration 900 Buildings 6 ,000 Equipment 1 ,000 Vehicles 2,000 Debtors 3,400 Bank balance 1 ,800 Creditors 4,600 Capital a/c 18,000 Drawings 3 ,1 00

1.7 From the following information prepare an Income Statement and Balance Sheet.

Capital at 1 Jan. Building Motor vehicles Investment Debtors Cash Creditors Rent Rates Wages Purchases Sales Stock 1 Jan. Electricity Sundry expenses Motor expenses Stationery

Stock 31 Dec.= £2,500

15,000 6,000 5,000 9,000

200

350 570 980

17,000

200 130

50 120 90

£54,690

25,690

7,000

22,000

£54,690


1 .8 Which of the following items would appear in a Balance Sheet?

(a) The business is owed £7,500 by a debtor. (b) Stocks of goods held for resale are worth £13,800. (c) The premises in which the business stores clothing could be used for

manufacturing portable radios. (d) Motor vehicles, cost £4,900, are used by the business. (e) The business has difficulty in meeting promised delivery dates. (j) The business maintains good relationships with the workforce. (g) The business has a near monopoly of the product it is selling. (h) Suppliers are owed £22,500 by the business. (i) A proportion of the stock cannot be sold. (j) The premises, which originally cost £15,000, are now worth £23,000.

What were your reasons for stating that certain items would not appear on the Balance Sheet?

1.9 (A) Analyse the following information into two columns, the totals of which will agree, when an appropriate capital figure has been completed.

Freehold land and buildings at cost 8,000 Plant and machinery at cost 10,000 Fixtures and fittings at cost 5,500 Depreciation to 31 Dec.: Plant and machinery 6,000

Fixtures and fittings 950 Stock at 1 Jan. 3,000 Purchases 54,400 Sales 70,000 Creditors 1 ,020 Drawings 1 ,800 ~~ ? Cash in hand 550 Bank overdraft 1 ,500 Debtors 1 ,200 Wages 3,000 Insurances 170 General expenses 1 ,250 Rent and Rates 600

(B) Using the details of (A) and the following additional information, prepare a Balance Sheet and an Income Statement.

(i) There has been no provision made for unpaid rates amounting to £380.

(ii) £100 of the rent has been paid in advance. (iii) The annual insurance premium is £120. (iv) Depreciation is to be charged at 10% per annum on cost for plant

and machinery and fixtures and fittings .. (v) The stock at 31 December was valued at £3,200.

CHAPTER 2

Methods of Data Recording

In practice a considerable number of transactions take "place every day and for this reason a system of data recording is essential, this information being recorded in Accounts.

The accounting equation is Assets + Expenses + Drawings =

liabilities + Revenue Profit + Capital

and a movement of any one item is reflected by a complementary movement elsewhere. For example, the purchase of equipment on credit creates an asset and a corresponding liability.

This principle is used in the recording of accounting information so that items classified as assets, expenses and drawings appear on the left hand (Debit) side of an account, while liabilities, revenue/profit and capital appear on the right-hand (Credit) side.

An account would contain one or more of the items shown below and they would appear on the debit or credit side according to their nature.

Debit (Dr.)

An Account Credit (Cr.)

Receipts of Cash Assets Owned Expenses Incurred Value Given to Customers (Debtors) Drawings

Payments of Cash liabilities Owing Revenue Earned Value Received from Suppliers (Creditors) Capital

There is no logical reason for a debit entry appearing on the left-hand side of an account or a credit entry on the right-hand side; it is just historical practice. The dictionary definition of debit is 'to charge' and a debit entry in an account represents a charge to an individual or business, an expense or asset, on the basis that historically the accountant was charged with responsibility of accounting for cash. Since the accounting system recognises that whenever a transaction takes place two parties are involved, the charge (a debit) must be related to corresponding liability or income (a credit).


The following transactions will be illustrated: (A) proprietor introduced Capital, £4,200 (£4,000 at the Bank and £200 Cash in Hand); (B) purchased Stock £500, paid by cheque; (C) purchased Plant £1,000, paid by cheque; (D) withdrew £50 in Cash for personal use; (E) sold 50% of Stock for £600 cash; (F) paid £725 into the Bank.

Bank Account

Capital (A) 4,000 Cash Banked (F) 725

Stock Purchased (B) 500 Plant Purchased (C) 1 ,000

Cash Account

Capital Introduced (A) 200 Stock Sold (E) 600

Drawings (D) Cash Banked (F)

Capital Account

Bank (A) Cash (A)

Drawings Account

Cash (D) 50 I

Bank (B)

Bank (C)

Stock Account

500 1

Sales Account

I Cash (E)

Plant Account

1,ooo 1

50 725

4,000 200

600

Notes: (1) These transactions were previously shown in the Balance Sheet of 'A' in Chapter 1.

(2) The creation of profit has been ignored at this stage. (3) In order that the transactions may be clearly followed they have

been referenced in accordance with the illustration. The following fundamental principles of book-keeping can now be stated: (1) Every transaction requires two entries of equal value, of which one will

appear on the Debit side and the other on the Credit side of the relevant accounts.

(2) An account is opened for each type of transaction so that transactions of a similar nature can be brought together. Businesses will open accounts according to their individual needs.

(3) Trading profits are not calculated until the end of an accounting period, costs and revenue being kept separately.

Methods of Data Recording 31

Closing the Accounts

At an appropriate time the balance on each account is calculated. This involves the addition of both sides of the account and subtracting the smaller figure from the larger. This balance is then analysed between the amount chargeable to the Income Statement and the proportion which is an outstanding Balance Sheet item.

(A) Proprietor introduced Capital £9,600 in the form of Premises, £8,000; Fixtures and Fittings £1,500; Cash in Hand £100.

(B) Purchased, on credit, Stock £800. (C) Sold, on credit, 25% of stock for £1,200. (D) Received from Debtors by cheque £850. (E) Paid Creditors by cheque £700. (F) Withdrew £50 in cash for personal use.

Cash Account Capital 100 Drawings {F) Introduced {A) Balance C/D

£100

Balance B/D 50

Premises Account

Capital 8,000 I Introduced {A)

50 50

£100

Fixtures & Fittings Account

Capital 1,500 I Introduced {A)

Capital Account Drawings {H) 50 Cash {A) Balance C/D 9,550 Premises {A)

Fixtures {A)

100 8,000 1,500

£9,600 £9,600-

Balance BID 9,550

Drawings Account Cash {F) 50 Transfer 50

to capital {H)

Bank Account

Debtors {D) 850 Creditors {E) 700 Balance C/D 150

£850 £850

Balance B/D 150

Stock Account Creditors {B) 800 25% Transfe"ed200

to cost of sales (G) Balance C/D 600

£800 £800

Balance B/D 600

Creditors Account Bank {E) 700 Stock 800

purchased {B) Balance C/D 100

Credit sales {C)

£800 £800

Balance B/D 100

Debtors Account 1 ,200 Bank {D) 850

Balance C/D 350

£1,200 £1,200

Balance B/D 350

Sales Account I Debtors {C) 1,200

Cost of Sales Account

Stock A/C 200 I {G)


List of Balances Debit Credit

Cash 50 Premises 8,000 Fixtures 1,500 Capital 9,550 Bank 150 Stock 600 Creditors 100 Debtors 350 Sales 1,200 Cost of Sales 200

£10,850 £10,850

The above balances are now allocated to the Profit and Loss Account or the Balance Sheet.

Profit and Loss Account or Income Statement

Cost of Sales 200 Sales 1,200 Profit Transferred to Capital 1,000

£1,200 £1,200

Balance Sheet

Fixed Assets Premises 8,000 Fixtures and Fittings 1,500

9,500

Current Assets Stock 600 Debtors 350 Bank 150 Cash 50

1,150 Less Current liabilities

Creditors 100

1,050

£10,550

Proprietor's Interest: Capital £10,550


(1) This example should be compared with the moving Balance Sheet of 'B' in Chapter 1, p.ll. The final result is the same by both methods.

(2) The accounts for debtors and creditors are summaries or total accounts. Details of individual customer's and supplier's accounts would be maintained elsewhere and the total of the balances on these individual accounts would agree with the balances on the total accounts.

(3) The Profit and Loss Account, previously referred to as the Income Statement, is a ledger account showing the results for a particular period.

Accounting for outstanding and prepaid expenses

It is necessary to account for accruals and prepayments for certain expenses, and the treatment of these items in the books of account is described in the following paragraphs.

Wages In the first year of business the organisation had paid £8,000 in cash for

wages. PA YE £1,620 was deducted from wages, of which £1,500 had been paid. Pension contribution was £250. At the end of the first financial year £160, representing one week's gross wages, was due but had not been paid. The Wages Account is used to calculate the wages for the period under review.

Cash PAYE Pensions

Wages Account

8,000 Income 10,030 1,620 Statement

Cash 250

Amount due Creditor

c/d 160

£10,030 £10,030

Balance b/d 160

PA YE Account

Cash 1 ,500 Wages 1,620 Balance c/d 120

£1,620 £1,620

Balance b/d 120

The law requires that before an employer pays his staff he is obliged to make certain deductions which he pays over to government agencies on behalf of the employee. These include PAYE, graduated pension and insurance. In calculating the outstanding amount at the end of a financial period an estimate of the gross liability is made but there is no legal liability for the deductions until the wages are actually paid.

The amounts due, Gross Wages £160 and PAYE £120, will be shown as liabilities on the Balance Sheet.

The charge of £10,030 to the Income Statement represents the total cost of wages for the financial period.

In the following year the transaction were: wages paid, £8,200; PA YE paid, £1,600 and Insurance, £260. Outstanding wages at year end amounted to £180 and £130 was due for PAYE.


Wages Account PA YE Account Cash 8,200 Balance b/d 160 Cash 1,600 Balance 120 Cash Ins. 260 Income 10,090 b/d

Statement Balance 130 Deduction 1,610 PAYE 1,610 c/d from Wages Amount due

£1,730 £1,730 Creditor c/d 180 Balance b/d 130

£10,250 £10,250

Balance b/d 180

The opening creditor for wages, £160, has been settled by a combination of cash payment to the employees included in the £8,200, a PAYE deduction transferred to the PAYE account and the cost of insurance included in the figure of £260.

The amount due for PAYE at commencement of the year, £120, was settled in the cash payment of £1,600. The closing creditor, £130, represents deductions of PA YE from Gross Wages not yet paid to the Inland Revenue.

The use of the PAYE Account demonstrates one technique of book-keeping involving the account being used as a holding or collecting account for funds due to outside parties. In the case of PA YE this is the Commissioners of Inland Revenue.

Gross Wage

£60

Income Tax

£15 I

Creditor- PAYE 1 Amount due £ 15 (Wages Control)

Creditor - Insurance Deductions

Ins.

£3

from pay £3-Coy. Cont. £4 (Wages -

Control) £7 -

Creditor - Pensions Deductions £1 Coy. Cont. £2 (Wages Control) £3

These creditors will be paid in accordance with the necessary regulations, e.g. Insurance and PAYE by 15th of each month, pension contributions quarterly.

Pens.

£1

Total deds.

£19

Net Wage

£41

Coy. ins.

£4

Coy. pens.

£2

Bank -- - -1NetWage 41

Wages Control -l-Cash 41

PAYE 15 Ins. 7 Pens. 3 -

£66

Note: Gross Wage Coy. Cont.

60 6

£66


Rent and Rates

A trader leases premises from 31 March at a rental of £2,800 per annum, payable in advance. His financial year ends on 31 December. Rates were £1 ,200, payable half-yearly in advance.

Rent Account 31 Mar. Cash 2,800

£2,800

Balance b/d 700

31 Dec. Prepayment ~yr. c/d 700 Income Statement

2,100 (9 mths)

£2,800

Rates Account 1 Apr. Cash 600 1 Oct. Cash 600

£1,200

Balance b/d 300

31 Dec. Prepaid ~yr. c/d 300 Income Statement

900

£1,200

The charge to the income statement, £2,100 Rent and £900 Rates, represents the cost of occupying the premises for a period of nine months, 31 March to 31 December. The prepayments represent amounts paid in respect of the following financial period. They will be shown as assets on the Balance Sheet on the basis that if the occupation of the premises is terminated the Rent or Rates paid since the end of the financial year would be refunded to the organisation

The accounts of the following year, on the assumption that Rates were not paid in October, would be as follows:

Rent Account Rates Account 1 Jan. 31 Dec. 1 Jan. 31 Dec. Balance Prepaid Balance Income b/d 700 c/d 700 b/d 300 Statement

1 Apr. (12 mths.) 1 Mar. Income Cash 600 1,200 Cash 2,800 Statement 31 Dec.

(12 mths.) Accrual 2,800 c/d 300

£3,500 £3,500 £1,200 £1,200

1 Jan. 1 Jan. 300 Balance Accrual b/d b/d 700

The Income Statement is now charged with the cost of twelve months' occupation of the premises. As the Rates were not paid in October the charge for the period October-December must be accounted for by creating the necessary creditor.


Insurance When calculating the charge for Insurance the main factor to be considered

is the period covered by the premium. In addition, it is necessary to know whether the amount paid is a premium or a deposit pending agreement on the final value of the insured item. Insurances of this nature include Stock, Goods in Transit and Money in Transit.

At the end of a financial year it therefore becomes necessary to make adjustments for premiums paid which extend beyond the end Qf the period and for premiums not yet finalised.

An organisation took out the following insurances during an accounting period of twelve months:

1 Jan.

1 Mar. 1 Jul.

Fleet Motor Policy, £3,600 Twelve months premium Stock in Transit, deposit £300 Public liability, Twelve months premium, £1,200

The financial period ended on 31 December when it was estimated that £350 would be the full charge for stock in transit movements for twelve months.

Insurance Account

1 Jan. Motor Ins. 3,600 31 Dec. Prepaid c/d 600 (public liability 1 Mar. Stock in period, 1 Jan

Transit 300 -30 June 1 Jul. Public Income Statement

liability 1,200 Motor Insurance 3,600 Stock 350 Pub. Liability 600

5,100 4,550 31 Dec. Amount due, i.e. Stock in 50 Transit c/d

£5,150 £5,510 --- ---

1 Jan. Balance b/d 600 Balance b/d 50

The account shows both a Prepayment and an Accrual and these will not be netted for Balance Sheet purposes as they may well relate to more than one insurance company. The accrual represents an amount due to an insurance company, whilst prepayments may only be repaid if the policy is cancelled before expiry date.

The charge to the Income Statement represents premiums relative to the financial year, calculated for the individual policies.


Depreciation

The majority of expenses appearing on the Income Statements incurred by the business involved the payment of cash, and this reduction in the assets of the business is matched by a corresponding reduction in the profit. There will, however, be items in the Income Statement which, while representing an expense, do not involve cash expenditure. One of these items is referred to as Depreciation and is an attempt by management to ascertain the cost of using the fixed assets of the business during the accounting period.

The charge so made is a purely arbitrary figure, being based on the expected life of each individual asset or each class of asset, and with the exception of a lease on property this period may be extremely difficult to determine. The purpose of depreciation is to apportion the original cost over a number of financial periods mainly to ensure that, so far as is possible, the results are shown on a consistent basis and no single year is charged with the total cost of a particular asset.

The charge may be arrived at by the formula:

Original Cost Es . d Ut = Annual Charge ttmate e

the estimated life being stated in years or total working hours. In the latter case it will be necessary to maintain records of the hours actually worked in order to calculate the annual charge. The annual charge may be stated as a percentage of the original cost or as a percentage of the original cost less all previous depreciation charges. The latter method will require a rate of approximately 3Y<I times the first method in order to eliminate the cost over the estimated life.


A piece of equipment is purchased at a cost of £2,000 and has an estimated life of 5 years. The depreciation charge would be calculated by either of the following methods:

Cost £2,000 Estimated life 5 years Annual rate 20% Annual charge £400

Yr. Cost £2,000 Depreciation 400 Written down value 1,600

2 Depreciation 400 Written down value 1,200

3 Depreciation 400 Written down value 800

4 Depreciation 400 Written down value 800

5 Depreciation 400 Written down value NIL

Method known as 'Fixed Instalment.'

Cost £2,000 Estimated life 5 years Annual rate 65% on value remaining Annual charge?

Yr. Cost £2,000 Depreciation

at 65% 1,300 Written down value 700

2 Depreciation at 65% on £700 455

Written down value 245

3 Depreciation at 65% on 245 160


4 Depreciation at 65% on 85 ____22


5 Depreciation at 65% on 30 __2Q_

Written down value 10 (charged to P and L in 5th yr)

Method known as 'Reducing Instalment' (Rate would be obtained from actuarial tables).

The Profit and Loss Account may well be showing an increasing charge in the later years for repairs and maintenance. Under the reducing instalment system this charge may to a certain extent be counteracted by the reducing depreciation charge.

As the accounting entries are the same irrespective of the method used for arriving at the annual charge, it is intended to demonstrate only the ft.xed instalment method, because it is considered that an understanding of the accounting techniques are of more importance than the method of calculating the annual charge.

An organisation leases premises for 50 years at a total cost of £100,000 paid on occupation of the premises. This will involve an annual charge of £2,000 for depreciation or amortisation of the lease (£100,000/50).

Lease Account

Yr. 1 100,000 Cash

Yr. 50 Depn.

100,000


Depreciation Provision

Yr.50 100,000 Transfer to Lease

£100,000

Yr.l 2,000 Income Statement Yr. 2- do- 2,000

4,000 Yr. 3- do- 2,000

6000 4-50-do-94,000

(47 yrs x 2) ---£100,000

The annual provision for depreciation is charged to the Income Statement and accumulated over the period of 50 years in the provision account. On the expiry of the lease the accumulated depreciation, which is appropriated profit, is transferred to the asset account in order to eliminate the original cost.

It must be emphasised that the annual charge for depreciation appears in the Profit and Loss Account with a corresponding entry in the Depreciation Provision. In subsequent years the annual charge to the Profit and Loss is added to the accumulated balance on the Depreciation Provision, this then being shown on the Balance Sheet as a deduction from the relative Fixed Assets. Under no circumstances is the accumulated charge written back to the Profit and Loss Account.

A business organisation whose fmancial year ends on 31 December purchased a piece of plant on 1 January for £20,000. The plant had an expected life of ten years. On 30 June in the following year a further purchase at a cost of £30,000 was made, this equipment having an estimated life of five years.

Depreciation commences, and is calculated, from the date of purchase.

Plant

Yr.1 20,000 Cash Yr. 2 30,000 Cash

£50,000

Plant Depreciation Provision

Yr.1 2,000 Income Statement 1/lOth of20,000 Yr. 2 5,000 Income Statement 1/10th of 20,000 + 1/5th of 30,000 for 6 months.

7,000 Yr. 3 8,000 Income Statement 1/lOth of20,000 1/5th of 30,000

---£15,000


The control of the assets is maintained by means of a plant register and the asset and provision accounts are total, or control, accounts of all transactions.

The depreciation provision charged to the Income Statement is not an expense giving rise to an outflow of funds but is an appropriation of profits on an annual basis to offset the original cost of the asset. If the whole of the cost were to be charged to the Income Statement in the year of purchase, the effect would be to distort the profit in that and subsequent years.

Asset Disposals

When an asset is of no further use and is scrapped or sold it is necessary to write the asset out of the fmancial records. This is carried out by transferring the cost and the accumulated depreciation to an asset disposal account.

Where the accumulated depreciation is less than the cost the balance of the cost will be charged to the Income Statement for the financial period in which the asset was sold.

A vehicle is purchased for £500 with an estimated life of five years. It is scrapped at the end of the third year.

Yr.l Cash

Vehicle Account

500 Yr. 3 500 Disposal Account


Yr.3 Disposal Account

300 Yr. 1 P and L 100

£300

2-do- 100

200 3- do- 100

£300

Vehicle Disposal Account

Yr. 3 Cost 500 Yr. 3 Depn. 300 Yr. 3 Loss 200 (Income Statement)

£500 £500

A full year's depreciation has been charged in the year of disposal. Where the asset is sold either during, or at the end of, its estimated life the

cash received will not be treated as income in the Income Statement but will be lodged in the disposal account and, together with the accumulated depreciation, will be set against the original cost. The profit or loss arising on the sale will be either credited or charged to the Income Statement on the basis that such profit or loss has arisen due to an under-or over-provision of depreciation during the life of the asset.


A company purchases a vehicle for £1 ,200 and proceeds to depreciate it over four years. It is subsequently sold at the end of the third year for £320.

Yr.l Cash

Vehicle Account

1,200 Yr. 3 1,200 Disposal Account

Vehicle Depn. Provision

Disposal Account

900 Yr. 1

£900

Income Statement 300 Yr.2 - do -300

600 Yr. 3- do- 300

£900


Yr. 3 Original Cost (Asset a/c)

Income Statement (Profit on sale)

Note: Original Cost Depreciation

Written down value Cash proceeds

Profit

1,200

20

£1,220

£1,200 900

300 320

£20

Cash Depn. Provision

320 900

£1,220

A company's financial year commences on 1 January and the following transactions took place during the subsequent twelve months.

Balances at 1 Jan. Sales at 31 Mar. - Original Cost

Proceeds Additions at 30 June- Cost Sales at 30 Sept. - Original Cost

Proceeds Additions at 31 Oct. - Cost

Plant Account

£49,200 £18,000 £ 2,500 £ 6,000 £ 7,200 £ 5,000 £ 9,600

Depn. Provision

£28,500

Sales at 31 March comprised three items: £4,000, £8,000 and £6,000 purchased 11 years, 8 years and 7~ years before commencement of current year.

Sales on 30 September comprised two items: £3,000 and £4,200 purchased 4* years and 2~ years prior to commencement of current year.

Annual depreciation rate is 10% on cost commencing at date of purchase and ceasing at date of sale.

SAL

ES

SCH

ED

UL

E

Cos

t D

ate

of

Dat

e o

f P

urch

ase

sale

4,00

0 31

Mar

. 8,

000

31 M

ar.

6,00

0 31

Mar

.

£18,

000

--

3,00

0 30

Sep

t. 4,

200

30 S

ept

--

7,20

0

£25,

200

PUR

CH

ASE

S SC

HE

DU

LE

Cos

t D

ate

of

Ann

ual

Pur

chas

e D

epn.

6,00

0 30

Jun

e 60

0 9,

600

31 O

ct

960

--

£1,5

60

Cal

cula

tion

of D

epre

ciat

ion

Cha

rge

for

Fin

anci

al P

erio

d an

d P

rofit

s or

Los

ses

Ari

sing

on

Sale

s

Age

at

Ann

ual

Tota

l B

ook

Pro

ceed

s P

rofi

t or

Dep

n. C

harg

e sa

le

Dep

n.

Dep

n.

Val

ue

Loss

(C

u"en

t Ye

ar)

IB~ y

rs.

400

4,00

0 N

il 8%

yrs

. 80

0 6,

600

1,40

0 20

0 (1

Jan

.-31

Mar

.) 7~ y

rs.

600

4,50

0 1,

500

ISO

-do

-

--

--

£15,

100

2,90

0 2,

500

(400

) £3

50

5% y

rs.

300

1,57

5 1,

425

225

(1 J

an. -

30 S

ept.)

3

yrs.

42

0 1,

260

2,94

0 31

5 -

do

---

-2,

835

4,36

5 5,

000

635

540

--

--

---

£17~35

7,26

5 7,

500

235

£890

Dep

n.fo

r Cu"~ntyr.

300

(I J

ul. t

o 31

Dec

.) 16

0 (1

Nov

. to

31 D

ec.)

--

£460

t :.:... 6J § ~

.... (3•

;:s s· r s· ~ :.:... .... 8 § .... ~·


Depreciation charge for year: Cost of Plant at 1 Jan. Less Cost of Sales in Year

10% Depreciation for Year Depreciation on Sales Depreciation on Purchases

49,200 25,200

£24,000

2,400 890 460

£ 3,750

Plant Account Depreciation Provision

1 Jan. 49,200 Bal. b/d

1 Jun. 6,000 Purchases 1 Oct. 9,600 Purchases

£64,800

1 Jan. Bal. b/d. 39,600

31 March Cost of Disposals 18 ,000 30 Sept. -do- 7,200 1 Dec. 39,600 Bal. c/d

---£64,800

31 Dec. Written Back on Sales (Disposal

a/c) Bal. c/d

17,935

14,315

£32,250


31 Mar. Cost 18,000 31 Mar. Cash 2,500 30 Sept. Cost 7,200 30 Sept. Cash 5,000 31 Dec. Profit 235 31 Dec.Depn.17,935

on Sale

£25,435 £25,435

Replacement of Assets

1 Jan. Bal. b/d 28,500 1 Dec. Profit/ Loss a/c 3,750

£32,250

1 Jan. Bal. b/d 14,315

The annual charge to the Income Statement by way of depreciation is, as has already been stated, no more than a method of charging the original cost of an asset against subsequent revenue. It is not a method of providing capital funds for the purchase of replacement assets when the occasion arises. The depreciation charge merely reduces the profit available for distribution by way of drawings or dividends to the proprietors, partners or shareholders. The current assets remaining in the business could, however, be used for other purposes, e.g. stock purchase.

Such funds should, however, be utilised by investment in a more definite asset for realisation when required. It will, however, be necessary to take into account the fact that the replacement cost may exceed the cost of the original asset and provision must be made accordingly.


The organisation decided to invest £10,000 each year but during the fourth year discovers that cost of replacement will be £128,000 and during the eighth year that replacement will cost £143,000. This additional cost must be provided for but has no effect on the £10,000 annual depreciation. The result of the increased investment, however, will be to restrict the cash available for drawings even though profits are available for distribution.

Investment Account

Year 1 Bank 2 Bank

3 Bank

10,000 10,000 20,000 10,000

30,000 4 to 7@ £14,000 56,000

86,000 8to 10@£19,00057,000

£143,000

Yr. 10 Proceeds From Sale 143,000

£143,000

Balance on Investments at end of year 3 is £30,000. A further £98,000 will apparently be required at the end of the ten-year period. It will, therefore, be necessary to invest £14,000 per year for the next seven years. At the end of year 7, when it is discovered that replacement will cost £143,000, the business is holding investments at a cost of £86,000; a further £57,000 must be provided in the remaining three years, that is £19,000 per year.

A corresponding adjustment will be necessary in the Profit and Loss account to indicate the amount actually available to the proprietors.

Income Statement Year 1 Year 4 Year 8

Sales 50,000 80,000 120,000 Cost of Sales 20,000 32,000 48,000 Expenses 12,000 22,000 30,000

32,000 54,000 78,000

Increase in Assets 18,000 26,000 42,000 Depreciation 10,000 10,000 10,000

Profit (Amount for Distribution) 8,000 16,000 32,000

Additional Replacement Cost 4,000 9,000

Assets (Cash) actually available for payment of Dividends £8,000 £12,000 £23,000

The above example has taken no account of the interest that would be earned on the investments. This would normally be reinvested, thus reducing the annual charge.


The withdrawal of additional cash would have no effect on the profits available for distribution to the proprietors who will consider that any balance on the Profit and Loss Account can be treated as an increase in their capital and may wish to withdraw funds which in fact are not available. To prevent the possibility of cash being withdrawn by the proprietors the profits represented by the increased cash investment should be withdrawn and placed in a separate account referred to as 'Plant Replacement Additional Cost Reserve'. These accumulated profits will subsequently represent a partial cost of the replacement assets.

Original Cost

Transfer to Plant

Cost at end of 10 years

Cost of new equipment

Sale of Investment

Plant A/c

£100,000 I Accumulated Depreciation £100,000


100,000 Annual charges Yrs. 1-10

Investments

143 ,000 Proceeds on sale

Plant Afc

143,000 1

Bank

143,000 I Plant purchase

Plant Replacement Reserve

Yrs 4-7 @ £4,000 (P and L A/c)

Yrs 8-10@ £9,000

100,000

143,000

143,000

16,000

27,000

£43,000

Funds in the form of cash have been withdrawn for investment purposes. These profits are now represented in the fixed assets and the retained profits represented in the Reserve are part of the Proprietor's Interest. As an alternative to placing cash outside the business the profits may be invested within the business, when it will be necessary to dispose of the assets represented by such profits in order to obtain the funds necessary for the purchase of new assets.

The following examples of the manner in which businesses might invest their funds should be studied.


A B

Capital 1,500,000 1,500,000 Profit and Loss 10,000 10,000 Plant replacement reserve 50,000

£1,560,000 £1,510,000

Fixed Assets cost depn.

Land 450,000 450,000 450,000 Plant 380,000 350,000 30,000 30,000

480,000 480,000 Investments 400,000 Current Assets

Stock 645,000 805,000 Debtors 90,000 280,000 Bank 5,000 5,000

740,000 1,090,000 Creditors 60,000 60,000

680,000 1,030,000

£1,560,000 £1,510,000

Company A has adopted a conservative policy towards asset replacement -the funds represented by the annual depreciation and subsequent appropriations taking into account increased cost have been invested outside the business. These can be sold to obtain the funds for asset replacement.

Company B has not adopted a policy which provides for asset replacement. Funds represented by retained profits including depreciation have been utilised within the business. When replacement becomes necessary current assets must be realised to obtain the required cash. A time lag between realising stock and obtaining payment may give rise to delay in purchase of fixed assets.

Generally when companies are considering investing their funds for plant replacement, consideration must be given to the rate of return in other businesses compared with their own business.

Bad Debts

Prior to the preparation of the final accounts it is essential that the value of all assets appearing on the Balance Sheet is as correct as can be ascertained. In this respect is is necessary to examine the debtors to ensure that every provision has been made against the possibility of non-payments and that Bad Debts likely to arise are charged to the Profit and Loss Account at the earliest opportunity.

There are two factors involved: (I) the known Bad Debts that have arisen in a trading period, and (2) the certainty that a proportion of the Debtors will not settle their accounts.


The former situation arises where customers are declared bankrupt, the latter is based on the company's previous experience.

A provision for bad debts is created in an attempt to charge possible losses to the trading period in which the revenue was earned. In the absence of a provision the bad debt would be charged in the trading period in which it was actually incurred.

Assume debtors are £5,000; known bad debts £100.

Debtors Bad Debts

Dec. 31 Bad Debt 100 Debtors Income Balance 5,000 Balance Balances Statement 100

c/d 4,900 Written off 100 ---

£5,000 £5,000

Balance b/d 4,900

There will be cases where a firm suspects that a debtor may be unable to meet their commitments or, for reasons of prudence, a general provision has to be made to cover the recognised risk of advancing credit. In these cases a Bad Debt Provision Account is set up, the purpose being to ensure that revenue is charged with the estimated bad debts for the period under review. The bad debts, when actually incurred, are then charged against the provision account.

Assume debtors are £4,900 and a provision of 5% is required for doubtful debts.

Balance b/d

Debtors

4,900

Bad Debt Provision

Income 245 Statement (5% of 4,900)

Notes: {1) As with depreciation the provision is not an outflow of funds: cash has not been paid away. (2) No entry is made in the Debtors Account when the provision is created; this will take place when the bad debt actually arises.

In year two actual bad debts were £230. At the end of the year debtors were £5,700 and a provision of 5% was again required.

Debtors Bad Debt Provision

Balance b/d 4,900 Bad Debt 230 Bad Debts 230 Balance b/d 245 Sales 15,000 incuned Balance 285 Pand L 270

in Year c/d (5% of Cash 13,970 5,700) Balance c/d 5,700

£515 £515 ---£19,900 £19,900

Balance b/d 285 Balance b/d 5,700


The charge to the Profit and Loss Account (£270) is made up of: 5% of £5,700 = £285 less Bad Debt Provision not required in the previous year of £15. Balance Sheet would show :

Debtors 5,700 Less Bad Debt Provision 285

£5,415 indicating the amount expected to be received from debtors.

Questions

2.1 Show the entries in the Stationery Account for the following transactions during the year ending 31 March 19-3, indicating the charge to be transferred to the Profit and Loss Account:

1 April 19-2. Stock of paper, etc., valued at £540. £210 was owing to suppliers, invoices not having been entered in previous financial year.

During the period 1 April 19-2 to 31 March 19-3, payments to suppliers were £4,630; this included £800 for goods delivered on 4 April19-3.

At 31 March 19-3 £380 was due to suppliers and stock was valued at £270.

Stationery at a cost of £60 had been taken during the year for private purposes.

2.2 The rent paid by a business is £1,800 p.a. due at the end of March, June, September and December in arrears. The financial year ends 28 February and rent had been charged to the end of the previous December. The rates for the premises are paid half-yearly in advance. These amounted to £840 for the half-year to 30 September, charged in April, and £960 for the half-year to 31 March, charged in October.

Show the entries in the Rent and Rates Account for the year ending 28 February 19-3.

2.3 The following charges for Insurance had been entered in the Insurance Account:

Fire Premium £4,800 year to 30 June, charged July. Burglary Premium £720 year to 31 October, charged November. Employer's Liability £1,000 Deposit+% of total wages; policy covers year to

31st December. Wages for year were £2m. The deposit had been charged in January 19-3; the balance on the policy

would not be charged until Aprill9-4. In February 19-3 the business had been charged with the additional

premium of% of £1,600,000 for the year to December 19-2. Show the entries in the Insurance Account for the year to 31 December

19-3.


2.4 A company makes up its accounts to 30 June each year and its vehicles are depreciated at 20% on cost. A full year's charge is made in year of purchase but no charge is made in year of sale. At 30 June 19-3 the Balance Sheet showed:

Motor Vehicles £82,450 (At cost) Depreciation Provision £46,690.

During the year to 30 June 19-4 the following transactions took place:

Purchases

Sales

HLV496L HLV997L

NBG12H UMA992J

Cost Proceeds Purchased

£4,250 £2,950

£ 795 £1,825

£110 £995

May 19-0 Sept 19-1

You are required to show the entries in the following accounts - Motor Vehicles, Depreciation Provision, Vehicles Disposal - in respect of the above transactions in the year ending 30 June 19-4 and to support your entries with supporting schedules.

CHAPTER 3

Summarising the Collected Data

The information required for the preparation of accounts will be obtained from the original documents, that is invoices from suppliers or to customers, notification of returns or over- or under-charges (credit notes), remittance advices to suppliers or from customers, and any other documents a business may consider necessary to ensure that accounts are written up accurately and convey the true state of the business.

In order to eliminate a vast amount of repetitive work the original documents may be summarised or listed and the main ledger of the business would record total transactions only, with the accounts of individual debtors and creditors being recorded separately in debtor and creditor ledgers.

The example which follows will demonstrate the manner in which this summarising might be carried out and the subsequent recording in the respective accounts.

When all the postings have been carried out it will be necessary to check the accuracy of the work and this is done by balancing the accounts and extracting a Trial Balance, a listing of all the balances in the ledger prior to the preparation of the Income Statement and Balance Sheet.

The Trial Balance, when agreed, is used as a working paper for the preparation of the final accounts and is also used for noting adjustments required to a number of the accounts in respect of items which (I) have not been entered prior to balancing and relate to the particular financial period (Accruals); (2) have been entered but relate to a subsequent financial period (Prepayments).

These adjustments include valuation of closing stock, depreciation charges, profits or losses on the sale of fixed assets, bad debt provision.

Summarising the Collected Data 51

B & J Black, trading as Black Bros., showed the following balances in their books at 1 January:

Leasehold shop Vehicles Cash Commissioners Inland

Revenue re P AYE

Depreciation Provisions

Premises Fittings Vehicles

£18,000 960

40

120

2,700 1,530

650

Fittings Bank Loan (Northern Finance Co.) Insurance Co. re Pension

Contributions

£4,560 4,200 3,600

175

Stocks £1,554 consisted of five televisions at £90 each, 16 radios at £60 each, nine hairdryers at £16 each.

Debtors £2,500 were D. Hyams (£700); W. Jones (£1 ,200); A. Williams (£600).

Creditors £1,315 were British Rail (£75); A. Jackson (£300); Printers (£690); SEEB (£250).

(I) From the above information calculate opening capital. (2) Open the necessary ledger accounts to show the above balances. (3) Record the following transactions in the necessary books or summary

sheets and write up the ledger accounts. (4) Prepare a Trial Balance and, taking into account the additional infor

mation provided, show the Profit and Loss Account for the month of January and a Balance Sheet as at 31 January.

Invoices received from suppliers Jan 2 Printers Ltd

Charles Ltd

5 Post Office SEGAS Trading Stamp Co.

12 A. Jackson Motor Mart

19 Charles Ltd

Town Property

22 British Rail Transit Insurance Co.

25 SEEB

Letterheads, £80; Typewriter, £250 12 Radios@ £60, £720 42 Hairdryers@ £16, £672 Telephone, £30 2 Heaters, £2,150 Cost of Stamps, £720 Building Repairs, £250 Vehicle, £1,275 (including tax and insurance, £75, to 31 March) 81 Televisions@ £90,£7,290 SO Radios@ £60,£3,000 Three months rent to 31 March, £750 Six months rates to 30 June, £720 Carriage charges, £70 Fire insurance premium, year to 31 Dec.£120 Electricity, £80


Invoices despatched to customers Jan 3 A. Williams

20 W. Jones

24 C. Arthur

Petty Cash transactions: Jan 1 £160 from bank

3 Travelling, £10 9 Petrol and Oil, £25

3 Televisions@ £135,£405 10 Hairdryers@ £24,£240 6 Radios@ £90,£540 15 Televisions@ £135,£2,025 20 Televisions@ £135, £2,700 20 Radios@ £90, £1 ,800

15 Advertising Situations Vacant, £28 22 Repairs, £35 23 Petrol and Oil, £33 25 Travelling, £12 29 Cleaning, £15

Stationery, £4 Postage, £18

Bank Receipts: Jan 1 W. Jones, £475; Discounts, £25; A. Williams, £600

3 Sale of Vehicle, £150 5 Cash Sales Banked, £4 ,500

20 Televisions@ £135,£2,700 17 Radios@ £90, £1,530 15 Hairdryers@ £24,£360 Gift Vouchers Redeemed, £90

9 W. Jones, £665; Discount, £35 11 C. Arthur, £2,430; Discount, £270 19 Cash Sales Banked, £5,627

25 Televisions@ £135,£3,375 20 Radios@ £90, £1,800 23 Hairdryers @ £24, £552 Gift Vouchers Redeemed, £100

25 D. Hyams, £350

Bank Payments: Jan 1 £160 to Petty Cash

5 Salaries, £220 12 Salaries, £250

P.A.Y.E., £120; Pension Fund, £175 19 Salaries, £260

George Hotel, £45 re accommodation 22 Charles, £890; Discount, £40

Printers, £655; Discount, £35 26 Salaries, £280; Insurance, £141. 31 SEEB, £250; A. Jackson, £300

Charles, £6,930; Discount, £360

Item

s no

t en

tere

d at

mon

th e

nd:

1.

A te

levi

sion

set

has

bee

n re

turn

ed b

y a

cust

omer

and

sub

sequ

entl

y re

turn

ed t

o su

ppli

er.

2.

10%

loa

n in

tere

st.

3.

Sala

ries

, £31

0; P

A Y

E, £

150;

P

ensi

ons,

£22

0.

4.

Dep

reci

atio

n: p

rem

ises

5%

p.a

.; fi

tting

s 10

% p

.a.;

veh

icle

s 25

% p

.a.

5.

Bad

deb

t,£

31

5,

D.

Hya

ms.

6.

Tra

ding

sta

mps

sto

ck v

alue

d £4

60

7.

Sto

ck i

nh

and

,£1

,21

8

8.

The

veh

icle

sol

d ha

d co

st

£720

2'h

yea

rs p

revi

ousl

y.

Acc

ount

ing

trea

tmen

t

Dr.

Inte

rest

, C

r. C

redi

tors

,

Dr.

Sala

ries

, C

r. C

redi

tors

, C

r. PA

YE

, C

r. Pe

nsio

n F

und

Dr.

Dep

n.,

Cr.

Dep

reci

atio

n Pr

ovis

ion:

Pr

emis

es,

Fitt

ings

, V

ehic

les,

Dr.

Bad

Deb

t, C

r. D

ebto

r,

Dr.

Sto

cks,

C

r. S

undr

y E

xpen

ses.

Dr.

Sto

ck,

Cr.

Purc

hase

s,

Dr.

Dep

n.

Prov

isio

n C

r. V

ehic

le

Dr.

Los

s on

Sal

e C

r. V

ehic

le

£ 30

£

30

£680

£3

10

£150

£2

20

£167

£ 75

£

62

£ 30

£315

£3

15

£460

£460

£1,2

18

£1,2

18

£450

£4

50

£120

£1

20

Exp

lana

tion

s Sa

le,

Deb

tor,

Pur

chas

e an

d C

redi

tor

susp

ende

d. A

ppro

pria

te

Cre

dit

Not

es w

ill f

ollo

w i

n Fe

b. P

rovi

sion

s w

ill b

e cr

eate

d in

th

e Sa

les

and

Purc

hase

s ac

coun

ts w

hich

will

be

set

agai

nst

Deb

tors

and

Cre

dito

rs.

The

se p

rovi

sion

s w

ill b

e el

imin

ated

by

th

e C

redi

t N

otes

whe

n po

sted

in F

eb.

Inco

me

Sta

tem

ent

mus

t sh

ow

cost

of

mon

ey

borr

owed

(1

0% o

n £3

,600

for

one

mon

th).

£310

re

pres

ents

am

ount

s du

e fr

om

prev

ious

pa

y da

y to

en

d o

f fi

nanc

ial

year

. T

he c

redi

tors

for

unp

aid

PA Y

E an

d Pe

nsio

ns

are

amou

nts

prev

ious

ly

dedu

cted

fr

om

sala

ries

no

t ye

t pa

id o

ver.

The

y ar

e an

add

itio

n to

the

net

sal

arie

s.

The

cos

t o

f us

ing

the

fixe

d as

sets

for

one

mon

th.

Cal

cula

ti

ons

acco

rdin

g to

dep

reci

atio

n sc

hedu

le.

The

as

set

debt

or

is

redu

ced

by

reas

on

of n

on-p

aym

ent;

re

venu

e is

red

uced

thr

ough

can

cell

atio

n of

sal

e.

Par

t of

the

exp

ense

inc

urre

d in

pur

chas

ing

trad

ing

stam

ps

carr

ied

forw

ard

to n

ext

fina

ncia

l pe

riod

whe

n th

ey w

ill b

e is

sued

aga

inst

sal

es.

The

cos

t o

f va

lue

of g

oods

rem

aini

ng o

n ha

nd a

t en

d of

fm

anci

al p

erio

d fo

r us

e in

fol

low

ing

peri

od.

Acc

umul

ated

de

prec

iati

on

for

peri

od

asse

t w

as

held

-

see

depr

. sc

hedu

le.

Dif

fere

nce

betw

een

book

va

lue

and

cash

pr

ocee

ds.

See

depr

ecia

tion

sch

edul

e.

V:l

:;:: ~ ~ .... o:;·

~- ..., ;:::~ g :::::: ~ ~ ..., ~ ~ ~ v, '""-'


In order to assist in the preparation of the final accounts it is necessary to do the following:

(I) Summarise items of a like nature, e.g. purchases and expenses on credit, sales on credit, cash transactions.

(2) Maintain separate debtor and creditor total accounts, these being supported by the entries in the individual accounts written up elsewhere in the organisation.

(3) Balance accounts prior to the extraction of the Trial Balance. (4) Maintain stock cards to assist in the valuation of closing stock. (5) Prepare schedules supporting the entries on the sale and purchase of

assets and the annual depreciation charges. (6) Carry out the final adjustments in both the Trial Balance and the

individual accounts.

Calculation of opening capital:

Leasehold Shop Fittings Vehicles Stocks Debtors Bank Cash

18,000 4,560

960 1,554 2,500 4,200

40

£31,814

Northern Finance Creditors PAYE Pension Fund Depreciation: Lease

Fittings Vehicle

:. Opening Capital

3,600 1,315

120 175

2,700 1,530

650

10,090 21,724

£31,814

Sum

mar

y o

f Pet

ty C

ash

Tran

sact

ions

Det

ails

R

ecei

pts

Pay

men

ts

Trav

el

Mot

or

Sund

ries

R

epai

rs

Stat

ione

ry P

osta

ge

Exp

ense

s

Jan

.l

Bal

ance

b

/f

40

Fro

m B

ank

160

Jan.

3

Tra

vel

10

10

Jan

.9

Petr

ol a

nd O

il 25

25

Ja

n. 1

5 Si

ts. V

ac.

28

28

Jan.

22

Rep

airs

35

35

Ja

n. 2

3 P

etro

l and

Oil

33

33

Jan.

25

Tra

vel

12

12

Jan.

29

Cle

anin

g 15

15

S

tati

oner

y 4

4 ~

Post

age

18

18

3 18

0 22

58

43

35

4

18

~ .... ~·

Bal

ance

c/

d 20

~·

;:;.

£2

00

£200

a/

c no

. IS

16

17

18

19

19

~ ~

Feb

.l

Bal

ance

b/

d 20

::::

: ~

..... ~

The

exp

endi

ture

of £

180

wou

ld b

e re

imbu

rsed

fro

m B

ank

and

ente

red

in t

he P

.C. s

umm

ary

as a

rec

eipt

on

1 Fe

brua

ry.

l:l.. ~

i:!' ~

v.

0\

~

A C

ASH

BO

OK

~

1::

Rec

eipt

s ~ ...

Tota

l D

ebto

rs

Cap

ital

Sale

s Su

ndri

es

Dis

coun

ts

(5•

;:::=

Jan.

I

Bal

ance

b/

f 4,

200

4,20

0 s·

W. J

ones

47

5 47

5 25

b::1

1:

: A

. Will

iam

s 60

0 60

0 "' s·

Jan.

3

Veh

icle

I 5

0 I 5

0 (1

> "' Ja

n. 5

C

ash

Sale

s 4,

500

4,50

0 "' ~

Jan

.9

W. J

ones

66

5 66

5 35

<

)

Jan.

II

C. A

rthu

r 2,

430

2,43

0 27

0 8 1:

: Ja

n. I

9

Cas

h Sa

les

5,62

7 5,

627

;:::= ...

Jan.

25

D. H

yam

s 35

0 35

0 ~·

£I8,

997

£4,5

20

£I 5

0 £I

O,I

27

£4,2

00

£330

Feb

. I

Bal

ance

b/

d 8,

32I

a/c

no

3 22

5/

24

5

Pay

men

ts

Tota

l Tr

ade

cred

itors

Sa

larie

s Su

ndri

es

Dis

coun

ts

Jan.

1

Pet

ty C

ash

160

160

14

Jan.

5

Sala

ries

22

0 22

0 Ja

n. 1

2 PA

YE

12

0 12

0 8

Pen

sion

17

5 17

5 9

Sala

ries

25

0 25

0 Ja

n. 1

9 Sa

lari

es

260

260

Geo

rge

Hot

el

45

45

15

Jan.

22

Cha

rles

89

0 89

0 40

P

rint

ers

655

655

35

Jan.

26

Sala

ries

28

0 28

0 In

sura

nce

141

141

Jan

.31

SE

EB

25

0 25

0 A

. Ja

ckso

n "3

00

300

Cha

rles

6,

930

6,93

0 36

0

£10,

676

£9,0

25

£1,1

51

£500

£4

35

Bal

ance

c/d

8,

321

£18,

997

a/c

no

25

7/24

7

Dis

coun

ts a

re e

nter

ed i

n th

e B

ank

Boo

k as

a c

onve

nien

t m

etho

d o

f po

stin

g ac

coun

ts. T

hey

do n

ot c

onst

itut

e re

ceip

ts o

r pa

ymen

ts

of

the

busi

ness

.

~

;:; ~ .... ... ~- ::;.

<1> ~

::::

<1> [ ~ ~ v. ~

Sum

mar

y o

f Pur

chas

e In

voic

es

v,

Oo

Supp

lier

To

tal

Stoc

k Te

leph

one

Ren

t and

Rat

es

Insu

ranc

e Su

ndri

es

Rep

airs

V

ehic

le

~

and

ligh

t and

hea

t F

ixed

ass

ets

Exp

ense

s ~

Pri

ntin

g §

Jan.

1

Prin

ters

Ltd

33

0 80

25

0 lS- .....

C

harl

es L

td

1,39

2 1,

392

cs· Ja

n. 5

Po

st O

ffic

e 30

30

:::

SEG

AS

2,15

0 2,

150

s· S

tam

p C

o.

720

720

t:x;, ::::

Jan.

12

A. J

acks

on

250

250

"' M

otor

Mar

t. 1,

275

1,20

0 75

s· ('I

> Ja

n. 1

9 C

harl

es L

td

10,2

90

10,2

90

"' "' T

own

Pro

pert

y 1,

470

1,47

0 ~

~

Jan.

22

Bri

tish

Rai

l 70

70

8

Tra

nsit

Ins

. 12

0 12

0 ::::

Jan

.25

SE

EB

80

80

:::

.....

£18,

177

11,6

82

110

1,55

0 3,

600

120

790

250

75

~·

A/c

Nos

. 7

4 19

20

1/

3 21

17

18

16

Eac

h do

cum

ent

wou

ld b

e se

rial

ly n

umbe

red

for

iden

tific

atio

n, t

his

bein

g en

tere

d in

the

sum

mar

y.

The

cla

ssif

icat

ions

are

int

ende

d to

be

an i

ndic

atio

n on

ly a

nd a

re n

ot e

xhau

stiv

e. T

he S

ales

Inv

oice

Sum

mar

y w

ould

inc

lude

car

riag

e, r

oyal

ty,

VA

T a

nd o

ther

cha

rges

not

par

t of

sale

s.

Sum

mar

y o

f Sal

es In

voic

es

Cus

tom

er

Tota

l TV

s R

adio

s H

air

Dry

ers

Jan.

3

A. W

illia

ms

645

405

240

Jan.

20

W. J

ones

2,

565

2,02

5 54

0 Ja

n.2

4

C. A

rthu

r 4,

500

2,70

0 1,

800

7,71

0 5,

130

2,34

0 24

0

A/c

Nos

. 5

22

22

22

Fittings ( 1)

Jan. 1 Balance 4,560 Invoices 2,400

£6,960

Jan. 1 Balance Invoices

Balance b/d

Jan. 1 Balance Invoices

Balance b/d Balance b/d

Jan 1 Balance Sales

Balance b/d Balance b/d


Leasehold Shop (2)

Jan 1 Balance 18 ,000

Vehicles ( 3)

960 1,200

£2,I60

1,440

Jan. 3 Sale Proceeds Jan. 31 Depn.

Loss on Sale Balance c/d

Stock (Cost of Sales) (4)

1,554 Jan 31 Balance c/d 11,682 Returns c/d

£13,236

I ,2I8 90

Cost of Goods Sold

Debtors (5)

2,500 Jan 31 Cash 7,710 Discounts

10,2IO

£I0,2IO

4,9IO 135

5,045

Bad Debt Balance

150 450 120

1,440

£2,160

1,218 90

11,928

£13,236

4,520 330

4,850 315

5,045

£10,210

Northern Finance Loan (6)

Jan. I Bal. b/d 3,600


Creditors(?)

Jan. 31 Cash Discounts

Balance c/d

9,025 435

9,460 10,032

£19,492

Jan. 1 Balance b/d Invoices

Feb 1 Balance b/d Return b/d

1,315 18,177

19,492

£19,492 9,942

90

10,032

Comm. In/. Rev. PA YE (8)

Jan. Bank 120 Jan1Balanceb/d 120 150

Pension Fund (9) Jan. Bank 175 Jan 1 Balance 175

Jan 31 AccrualSalaries 220

Depreciation: Fittings ( 11)

Jan.31 Petty Cash Bank

Jan 1 Balance b/d 1,530

Jan 31 P and L 62

£1,592

Capital ( 13) Jan 1 Balance

b/d 21,724 Jan 31

Profit for month 2,206

£23,930

Travel ( 15) Jan. 31

22 P and L 67 45

£67 £67

31 Accrual-Salaries

Depreciation: Lease ( 10)

Jan 1 Balance 2,700 Jan 31 P and L 75

£2,775

Depreciation: Vehicles (12) Jan 31

Written back to Vehicle a/con sale Bal. c/d

450 230

Jan. 1 Balance b/d 650

Jan 31 P and L 30

£680 £680

Feb 1 Balance 230

Petty Cash Control ( 14)

Jan 1 Bal. b/f Bank

Jan 31 40 Expend.

160 Bal.

£200

Feb. 1 Bal. 20

Vehicles Expenses ( 16) Jan. 31

Petty Cash Invoices

Jan 31 58 Ins. 75 Prepaid

Pand L

£133

Feb 1 Prepaid 50

180 20

£200

50 83

£133

General Expenses ( 17)

Jan. 31 Petty Cash Invoices

Jan. 31 43 Stamps

790 Stock c/d P and L

£833

Feb. 1 Balance 460

460 373

£833

Printing and Stationery ( 19) Postage and Telephone

Jan. 31 Jan 31 Petty Cash -do -Invoices

4 P and L 18

110

£132

Insurance (21) Jan. 31 Jan. 31

Invoices 120 Prepaid P and L

£120

Feb. 1 Bal. 110

Sundry Manufacturers (23) Jan.

Sales Vouchers 90 - do - 100

£190

Salaries (25)

Jan. Jan31 Bank 1,151 PandL PAYE 150 Pensions 220 Accrued c/d 310

132

£132

110 10

£120

1,831

£1,831 £1,831

Feb. 1 Accruals b/d 310


Jan. Petty Cash Invoices

Repairs (18) Jan. 31

35 P& L 250

£285

Rent and Rates

285

£285

Light and Heat (20) Jan.31 Jan 31

Invoices 1,550 Rent Prepaid Rates Prepaid P and L

£1,550

Feb. 1 Balance 1,100

Sales (22) Jan.31 Jan.31

Returns c/d 135 Invoices Trdg. a/c 17,892 Cash

£18,027

Vouchers -do-

Feb 1

500

600 450

£1,550

7,710 10,127

90 100

£18,027

Returns b/d 135

!an. Allowed per Bank Bk. P and L

Jan.31 Bal. c/d.

Jan. 31 -Sundry Debtor

Discounts (24) Jan.

Received per

330 Bank Bk. 105

£435

Loan Interest (26) Jan.31

30 Pand L

£30

Feb 1 Accrual

Bad Debts (27)

Jan.31 P and L

315

435

£435

30

£30

30

315


Trial Balance as at 31 January

Notes A/C No. Dr. Cr. Adjustments Dr. Cr

Bank - 8,321 Leasehold 2 18,000 Fittings 1 6,960 4501

8 Vehicles (2160-150) 3 2,010 120 7 Stocks - Cost of 4 13,236 90

Sales 1,218 5 Debtors (10,210- 5 5,360 135

4,850) 315 Northern Finance 6 3,600

1 Creditors (19,492- 7 10,032 90 9,460)

4 Depn. Prov.: Lease 10 2,700 75 4 Fittings 11 1,530 62

4/5 Vehicles 12 650 450 30 Capital 13 21,724 Petty Cash 14 20 Travel 15 67 Vehicle Expenses 16 133 50

6 General Expenses 17 833 460 Repairs 18 285 Printing, Stationery 19 132 Postage and Telephone Rent and Rates, 20 600 Light and Heat 1,550 500 Insurance 21 120 110

1 Sales 22 18,027 135 Sundry Manufacturers 23 190 Discounts 24 105 Salaries 25 1,151 680

2 Loan Interest 26 30 2 Interest Due 27 30 3 PAYE Due 8 150 3 Pensions Due 9 220 3 Salaries Due 310 4 Depreciation 167 5 Bad Debts 315 6 Trading Stamps 460 7 Stock in Hand 1,218 8 Loss on Veh. Sale 120

Ins. Prepaid 50 110

Rent and Rates 500 Prepaid 600

£58,368 58,368 £4,925 4,925


Total Trading & Profit Balance Sheet Dr. Cr LossA/c Assets Liabilities

Dr. Cr.

8,321 8,321 18,000 18,000 6,960 6,960 1,440 1,440

11,928 11,928

4,910 4,910

3,600 3,600 9,942 9,942

2,775 2,775 1,592 1,592

230 230 21,724 21,724

20 20 67 67 83 83

373 273 285 285 132 132

450 450 10 10

17,892 17,892 190 190

105 105 1,831 1,831

30 30

710 710 167 167 315 315

1,678 1,678 120 120

1,260 1,260

£58,570 58,570 15,791

Profit 2,206 2,206

£17,997 17,997 42,779 42,779


Cost of Sales Gross Profit

Travel Vehicle Expenses General Expenses Repairs Printing and Stationery Rent and Rates,

Light and Heat Insurance Salaries Loan Interest Bad Debts Depreciation Loss on Vehicle Sale

Net Profit

Income Statement for the Month of January

11,928 5,964

£17,892

67 83

373 285 132 450

10 1,831

30 315 167 120

3,863 2,206

£6,069

Sales

Gross Profit Discounts

17,892

£17,892

5,964 105

£6,069

Gross Profit is 50% of cost. This agrees with profit margin on individual items. Proof that invoicing, stock recording and valuation is correct.

The depreciation calculation has been overstated by £4. ( ~ of £240 = £20) (p. 70) an audit of the accounts should reveal this error. If the error is not considered material the accounts would not be adjusted.


Balance Sheet as at 31 January

Fixed Assets Cost Depn. Net

Leasehold Premises 18,000 2,775 15,225 Fittings 6,960 1,592 5,368 Vehicles 1,440 230 1,210

£26,400 4,597 21,803

Current Assets

Stocks 1,678 Debtors- Trade- 4,910 + 190 5,100

Prepayments 1,260 Bank 8,321 Cash 20

£16,379

Less Current liabilities

Creditors - Trade 9,942 Accrued Charges 710

10,652

Working Capital or Net Current Assets 5,727

27,530 Less Loan 3,600

Net Assets £23,930

Proprietor's Interests

Capital, 1 Jan. 21,724 Net Profit for Month 2,206

·---£23,930


In addition to the accounts showing the operating results a statement should be prepared indicating the manner in which the business has obtained and used its funds. This statement will reconcile profit earned with movement in cash and indicate the extent to which business expansion has been financed by internal profits.

Bank and Cash Balances at Commencement of Year Bank and Cash Balances at End of Year

Funds Statement

Net Profit per Income Statement Add Depreciation

Loss on Sale of Vehicle

Increase in Funds from Trading Proceeds from Vehicle Sale Increase in Creditors

Total Funds Generated Less Fittings Purchased

Vehicles Purchased Stock Increase Debtors Increase

Increase in Bank and Cash

Notes

2,400 1,200

124 3,860

£4,240 8,341

£4,101

£2,206 167 120

2,493 150

9,042

11,685

7,584 --£4,101

Note

2

3

4 5

6

(I) Depreciation and loss on vehicle are added to profit as neither of these have resulted in cash leaving the business. They are book entries only, transferring capital costs to revenue. The profit on cash basis was £2,493, subsequently reduced by the depreciation charge and the loss arising on the vehicle sale.

(2) The increase in creditors is £1,315 + 120 + 175 (1,610) at commencement of month and £9,942 + 710 (10,652) at the end of month and represents cash held back by the business. This enabled the business to purchase capital equipment and stock and extend the credit period to debtors.

(3) Fittings and vehicles purchased - as per accounts. (4) Stock increase= £1,554- £1,678 (5) Debtors at commencement

at end (5,100 + 1,260)

Cash not received by business

£2,500 6,360

£3,860


(6) The increase in available cash is greater than the profit earned, due mainly to the considerable increase in creditors, funds not paid away and the increase in debtors, funds not received.

(7) The statement draws attention to what becomes a cash problem - the funds required to pay creditors. (£8,341 of cash to pay £10,652 creditors or the increase in creditors £9,042 is twice the increase in available cash £4,101.)

Subsidiary Records

Personal Accounts - Debtors

D. Hyams (1)

Jan. 1 Jan. 25 Balance 700 Bank 350

Bad Debt 315 Balance 35

£700 £700

Feb. 1 Balance 35

A. Williams ( 3)

Jan. 1 Balance 600 Jan. 1 Cash 600 Jan. 3 Sales 645 Jan. 31 Balance 645

£1,245

Feb. 1 Balance 64 5

£1,245

W. Jones (2)

Jan. 1 Balance 1,200 Jan. 1 Cash and Jan. 20 Sales 2,565 Discount 500

Feb.1 Balance

£3,765

2,565

Jan 9 - do - 700 Jan 31 Balance 2,565

£3,765

C Arthur (4)

Jan. 24 Sales 4,500 Jan. 11 Cash 2,700 Balance 1,800

£4,500 £4,500

Feb.1 Balance 1,800


Personal Accounts - Creditors

Jan. 22 Cash Discount

Jan. 31 Balance

British Rail ( 1) Jan. 1 Balance 75 Jan. 22 Invoices 70

£145

Printers ( 3) Jan. 1 Balance 690 Jan. 2 Invoices 330

690

330

£1,020 £1,020

Feb. 1 Balance 330

Post Office ( 5)

j Jan. 5 Invoices 30

Trading Stamp Co. (7)

Jan.31 Cash Balance

I Jan. 5 Invoices 720

Town Property (9)

I Jan. 19 Invmces 1,4 70

SEEB (11) Jan 1 Balance 250

250 Jan. 31 Invoices 80 80

£330 £330

Feb. 1 80

A. Jackson (2)

Jan. 31 Bank 300 Jan. 1 Balance 300 Balance 250 Jan. 12 Invoices 250

Jan. 22 Cash Discount

Jan. 31 -do-

Balance

£550 £550 Feb. 1 Balance 250

Charles Ltd. ( 4)

Jan.2 Invoices 1,392

930 Jan. 19 Invoices 10,290

7,290

8,220 3,462

£11,682 £11,682

Feb.1 Balance 3,462

SEGAS(6) I Jan.5 Invoices 2,150

Motor Mart (8)

1Jan.17 Invoices 1,275

Transit Insurance (I 0) J Jan. 31 Invoices 120

The preceding balances total £5,045 and £10,032, agreeing with the control accounts.


Stock Record 1

Description Code Price

Televisions 902 £90

Date Reference Delivered Despatched Balance Value

Jan. 1 5

Jan. 3 D/N* 3 2

Jan.3 GRNt 81 83

Jan. 5 D/N 20 63

Jan. 19 D/N 25 38

Jan. 20 D/N 15 23

Jan. 24 D/N 20 3 £270

*D/N Sales Invoice. t GRN Goods Received.

Stock Record 2

Description Code Price

Radios 975 £60

Date Reference Delivered Despatched Balance Value

Jan 1. 16

Jan. 2 GRN 12 28

Jan. 5 D/N 17 11

Jan. 5 GRN 50 61

Jan. 19 D/N 20 41

Jan. 20 D/N 6 35

Jan. 24 D/N 20 IS £900


Stock Record 3

Description Code

Hairdryers 1214

Date Reference Delivered Despatched Balance

Jan. 1

Jan. 2 GRN 42

Jan.3 D/N

Jan. 5 DIN

Jan. 19 D/N

Depreciation

Sales - Vehicles

Cost Depn. Annual Age at rate charge sale

9

51

10 41

15 26

23 3

Total Book Proceeds Profit/ depn. value (Loss)

Price

£16

Value

£48

Depn. this period

£720 25% £180 2% yrs. £450 £270 £150 (£120) Nil

Period Charges Rate Annual Charge this

charge period

Premises Balance £18,000 5% £900 75

Fittings Balance £ 4,560 10% £456 £38 Purchases 2,400 240 24 ---

£ 6,960 62

Vehicles Balance £ 960 Sales 720

240 25% 60 5 Purchases 1,200 300 25

£ 1,440 30

Total for Period £167

Where the Trial Balance does not agree it will be necessary to undertake a systematic check of all the work carried out since the previous Trial Balance was prepared in order to identify the errors.


These errors may consist of: (I) incorrect additions in one or more accounts; (2) incorrect extraction of balances from one or more accounts: (3) incorrect postings from summary sheets as between two accounts; (4) omission of balances from the Trial Balance.

During the course of checking for the difference on the Trial Balance other errors may be located which, however, do not create a difference. These ··rill include (1) complete omission of an entry in the summary sheet or posting to ledger; (2) treatment of capital expense (purchase of new vehicle) as revenue expense (motor vehicle running costs); (3) misposting as between two accounts of similar nature, plant for office equipment, heating for telephone.

When all errors have been located and adjustments to the Trial Balance carried out, including the accruals prepayments, etc., the ledger accounts must incorporate the changes before commencement of the new financial period.

The following is a further example, showing adjustments usually made to a Trial Balance, together with accounting entries, to give effect to the adjustments.

Sales 18,355 Purchases 12,556 Stock at Commencement 3,776 Salaries 2,447 Motor Expenses 664 Rent and Rates 456 Insurance 146 Ught and Heat 665 Vehicles 2,400 Fittings 700 Debtors 4,577 Creditors 3,114 Bank 4,032 Drawings 2,050 Capital 13,000

£34,469 £34,469

Additional Information: (I) Stock at end of year, £5,918. (2) Expenses owing: Motor, £56; Rent, £40 (3) Expenses in advance: Rates, £76; Insurance, £30 (4) Bad Debt, £150. A provision for further possible £80 is required. (5) Depreciation: Fittings, 10%; Vehicles, 25%. (6) Salaries outstanding, £75.

Note alternative method of calculating cost of sales. (1) To arrive at cost of sales add opening stock to purchases, deduct closing

stock: Cr. Stock Dr. Purchases Cr. Purchases Dr. Stock

£3,776 £5,918


(2) Outstanding charges will increase expenses: Dr. Motor Expenses £56 Dr. Rent £40 Cr. Creditors £96

(3) Expenses on Trial Balance include rates for a subsequent period; these must be eliminated:

Cr. Rates £76 Cr. Insurance £30 Dr. Debtors £106

(4) The Bad Debt incurred reduces Debtors and creates an expense. The possibility of further Bad Debts means the creation of a reserve. Debtors not reduced until Bad Debts actually incurred although Balance Sheet will show net Debtors:

Dr. Bad Debts (£150 + £80) Cr. Debtors Cr. Bad Debt Provision

(5) Depreciation charge is £670 - 10% of Fittings: (£700) = £70; 25% of £2,400 (Vehicles)= £600

A charge must be made against profits to create the Provisions:

£230 £150

£80

Dr. Depreciation (Profit and Loss a/c) £670 Cr. Depreciation Provision - Fittings £70 Cr. Depreciation Provision- Vehicles £600

(6) Salaries not having been paid for some part of the last month creates an additional expense:

Dr. Salaries Cr. Creditors

£75 £75

Tria

l Bal

ance

Trad

ing

and

Ori

gina

l A

djus

tmen

ts

Tota

ls

Pro

fit a

nd L

oss

A/c

B

alan

ce S

heet

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Ass

ets

Lia

bilit

ies

Sale

s 18

,355

18

,355

18

,355

Pu

rcha

ses

12,5

56

3,77

6 5,

918

10,4

14

10,4

14

Sto

ck

3,77

6 5,

918

3,77

6 5,

918

5,91

8 Sa

lari

es

2,44

7 75

2,

522

2,52

2 M

otor

Exp

ense

s 66

4 56

72

0 72

0 R

ent

and

Rat

es

456

40

76

420

420

Insu

ranc

e 14

6 30

11

6 11

6 L

ight

and

Hea

t 66

5 66

5 66

5 V

ehic

les

2,40

0 2;

400

2,40

0 F

itti

ngs

700

700

700

Deb

tors

4,

577

106

150

4,53

3 4,

533

Cre

dito

rs

3,11

4 75

+96

3,

285

3,28

5 ~

Ban

k 4,

032

4,03

2 4,

032

~

Dra

win

gs

2,05

0 2,

050

2,05

0 ~

Cap

ital

13

,000

13

,000

13

,000

...

Bad

Deb

ts

230

230

230

t:::·

Bad

Deb

t Pr

ov.

80

80

80

~-D

epre

ciat

ion

670

670

670

.., ~

Dpn

. Pro

v. V

ehic

les

600

600

600

"' F

itti

ngs

70

70

70

g ::::::

34,4

69

34,4

69

£10,

871

10,8

71

35,3

90

35,3

90

15,7

57

"' " .... P

rofi

t or

(L

oss)

2,

598

2,59

8 a

£18,

355

18,3

55

19,6

33

19,6

33

~ s T

he F

inal

Acc

ount

s w

ould

be

prep

ared

in

the

norm

al m

anne

r.

~


Trading and Profit and Loss Account for the Year Ending 31 December

Sales Cost of Sales

Gross Profit Salaries Motor Expenses Rent and Rates Insurance Li¢lt and Heat Bad Debts Depreciation

Net Profit

2,522 720 420 116 665 230 670

18,355 10,414

7,941

5,343 £ 2,598

Balance Sheet as at 31 December

Fixed Assets Cost Depn. Fittings 700 70 Vehicles 2,400 600

£3,100 670

Current Assets Stocks 5,918 Debtors and Prepayments 4,533 Less Bad Debt Provision 80

4,453 Bank 4,032

£14,403 Less Current Liabilities

Creditors and accrued Charges 3,285

Net Current Assets or Working Capital

Proprietor's Interest Capital, 1 January 13,000 Add Profit for Year 2,598

15,598 Less Drawings 2,050

Net 630

1,800

2,430

11,118

£13,548

£13,548


The previous examples have shown an agreed Trial Balance. The following example indicates the procedure where a difference arises and the manner in which corrections are carried out. When the Income Statement has been prepared and a Net Profit transferred to the proprietor's capital, and errors subsequently located, the profit will have to be adjusted as will the respective items on the Balance Sheet.

Trial Balance

Dr. Cr. Errors Corrected Dr. Cr.

Proprietor's Interest 11,215 Bank Charges 85 75 Drawings 620 Shop Fittings 5,300 Vehicles 1,800 Provision for depn.

Fittings 2,700 Vehicles 450

Salaries 2,520 Rent and Rates 1,815 tight and Heat 1,760 64 Motor Vehicle Expenses 1,592 Discounts 143

83 30 Purchases and Sales 6,492 9,358

10 40

Bank Balance 192 384 Stock at Commencement 313 Debtors and Creditors 1,359 541 40 83 General Expenses 120

£23,991 £24,264 £328 £601

Note: Original difference £24,264 - 23,991 = 273 Corrections £601 -328 = 273

The following errors were subsequently located: (I) Balance on the Sales Account overstated £10. (2) Discount received £15 had been posted as a debit to discount allowed. (3) Purchases £40 returned to a supplier had not been recorded in the books. (4) Bank Charges £75 entered in the Cash Book had not been posted to the

expense account. (5) Goods returned by a customer £83 had not been recorded. (6) The accrued charge of £64 on tight and Heat at end of previous financial

period had not been brought forward. (7) The Balance at bank was, in fact, an overdraft. (8) The balance on General Expenses £120 had been omitted.


(I) Dr. Sales

(2) Cr. Discount

(3) Dr. Supplier Cr. Purchases

( 4) Dr. Bank Charges

( 5) Dr. Sales

Cr. Debtors

(6) Cr. Ught and Heat

(7) Cr. Bank balance

(8) Dr. General Expenses

Net Profit adjustments: Add (2) £30 Discount

(3) £40 Purchases (6) £64 light and Heat

Less (1) £10 Sales (4) £75 Bank Charges (5) £83 Sales (8) £120 General

Expenses

Questions

Notes:

£10

£30

£40 £40

£75

£83

£83

£64

£384

£120

Balance to be reduced. This is overstated. The expense is overstated as a result of a debit entry of £15 in error for a credit entry. As a result of the omission both purchases and creditors are overstated. The expense is understated due to charge not being entered in the account. Both the revenue account (Sales) and the asset account (Debtors) are overstated as a result of omitting the entry. The balance on the expense account is overstated due to the failure to bring down the opening credit balance. The balance shown of £192 on the Trial Balance must be eliminated and the credit balance £192 inserted. The expenses have been incurred and posted to the account but the balance was not included when the Trial Balance was extracted.

Expense overstated. Costs overstated -goods returned. Expense overstated. Revenue overstated. Expense omitted. Revenue overstated.

Expense omitted.

3.1 The following Trial Balance was extracted from the books ofMr Jackson, a sole trader, at the end of his last financial year at 30 June, 19-2:


Debtors Purchases Drawings Cash in Hand Wages Capital at 1 July 19-1 Rates, Heating, etc. Sales Telephone charges Bank Interest Bank overdraft Freehold Premises, at cost Furniture and Fixtures, at cost Stock at I July, 19-1 Creditors Provision for Depreciation on Furniture

and Equipment, at 1 July, 19-1

Dr. I2,430 83,372

2,200 632

14,624

864

372 224

19,200 4,000

10,434

£148,352

The following information was also obtained: {a) Depreciation is at 10% p.a. on cost of Furniture and Fixtures. (b) Accrued expenses were: wages £240; heating £86. (c) Rates were prepaid to the extent of £36.

Cr.

24,188

109,636

4,292

9,836

400

£I48,352

{d) Stocks at 30 June I9-2 were valued £8,2I4 at cost and £9,017 at net realisable value.

You are required to prepare the Profit and Loss Account and the Balance Sheet of the firm.

3.2 W. Ashling, trading as Ash Ltd, showed the following balances in their books at 1 October:

Leasehold Shop £8,000; Fittings £4,500; Vans £800; Stocks £I ,070; Bank £4,200; Loan {City Bank Ltd.) £4,200; Comm. Inl. Rev. £120; Ins. Co. re Pensions Cost £I75. Depn. Provisions: Premises £2,000; Fittings £I ,360; Vehicles £500. Creditors £1,3I5; Debtors £2,500. You are informed that Stocks consisted of 5 Radiograms @ £90 each; 9 Sink

Units @ £60; I6 Coffee Sets @ £5. Debtors comprised: C. Arthur £500, D. Hyams £700, W. Jones £I ,200,

A. Williams £IOO. Creditors consisted of: British Rail £75, A. Jackson £300, Printers Ltd £690,

SEEB £250. You are required to:

(A) Show calculation of Capital at beginning of month. (B) Open the necessary ledger accounts to record the above balances. (C) From the information given below you are to write up:

(I) Purchase, Expenses, Sales and Petty Cash Journals. (2) Stock Cards.


(3) Bank Book. ( 4) Open the necessary personal and expense accounts. (5) Prepare a Trial Balance. (6) Taking into account the additional information given at month

end, prepare a Trading and Profit and Loss Account for the month of October and a Balance Sheet as at 30 October.

Invoices received from suppliers of goods and services: Oct. 2 Printers Ltd Letterheads £80

Furnishers Ltd 12 Sink Units @ £60 each £720 Charles Ltd 42 Coffee Sets@ £5 each £210

Oct. 5 GPO Telephone charges £30 SEGAS 2 Heaters (for internal use) £150 Trading Stamp Co. Cost of Stamps supplied £720

Oct. 12 British Rail Carriage charges £70 Wholesale Electrical 81 Radiograms @ £90 £7,290 Furnishers Ltd 50 Sink units@ £60 £3,000 Kingston Motors Cost of new vehicle £1 ,115 incl.

Oct. 18 Town Property Surbiton Stationery Traders Insurance Co.

Tax and Ins. £75 (to 31 Dec.) Rent 3 months to 31 Dec. £750 Typewriter £80

Oct. 24 SEGAS SEEBOARD

Oct. 28 Tolworth Garage Surbiton Stationery A. Jackson

Invoices despatched to customers: Oct. 3 C. Arthur Oct. 5 W. Jones Oct. 9 A. Mason Oct. 13 E. Evans Oct. 18 A. Williams Oct. 22 C. Arthur

Petty Cash Transactions: Oct. 2 Received £160 from Bank Oct. 3 Paid £10 Travelling

Fire Insurance premium for 1 year £120. Deposit on Cash in transit £20. Ugh ting £30 Power charges £80 Vehicle Repairs £25 Packing Material £460 Building Repairs £250.

3 Radiograms@ £135 10 Coffee Sets @ £7.50 6 Sink Units@ £90 15 Radiograms@ £135 20 Radiograms@ £135 20 Sink Units @ £90

Oct. 9 Paid £25 to Van Driver for Petrol and Oil Oct. 12 Paid £15 Laundry Oct. 13 Paid £28 Sits. Vac. Adverts Local Newspaper Oct. 18 Paid £15 Surbiton Stationery sundry stationery supplies. Oct. 24 Paid £20 H. Jackson repairs. Oct. 30 Paid £10 Laundry.

Bank Transactions- Receipts: Oct. 2 C. Arthur £475 Oct. 6 W. Jones £1,140

A. Williams £100

Discount £25 Discount £60

£405 75

540 2,025 2,700 1,800


Oct. 11 Proceeds from sale of old vehicle £100 (original cost £200, book value £75)

Oct. 19 C. Arthur £365 Discount £40 Oct. 29 A. Williams £2,138

E. Evans £1,823 Discount £202 C. Arthur £1,800 Cash Sales banked in month £9,500 (45 Radiograms@ £135; 37

Sink Units@ £90; 38 Coffee Sets@ £7.50) (Balance between actual sales and cash banked is represented by

gift vouchers not yet redeemed by suppliers). Bank Transactions - Payments

Oct. 2 £160 to Petty Cash Oct. 5 Salaries £220 Oct. 12 Salaries £255 Oct. 19 Salaries £280

Commissioners of Inland Revenue £120 Insurance Co. re Pensions Contributions £175

Oct. 22 Rates 6 months to 31 March £720 Oct. 26 George Hotel, Newtown £55 re Traveller's Accommodation

Salaries £325 Oct. 30 British Rail £145

Furnishers Ltd. £1 ,800 Discount £185 GPO £30 A. Jackson £285 Printer £660 SEEB £250 SEGAS £150 Town Property £750

Discount £15 Discount £30

Wholesale Electrical £6,480 Discount £720 Adjustments at month end, in addition to information to be derived from

above transactions: (1) No entries have been recorded in respect of one radiogram returned by

A. Williams and subsequently returned to the supplier, Wholesale Electrics. (2) The loan carries interest at the rate of 10% p.a. (3) Stock of Packing Material is valued at £120. ( 4) £260 of the balance due by D. Hyams to be written off as a Bad Debt. (5) No entries have been made in respect of outstanding PA YE £130 and

Pension contributions £295. (6) Advertising charges not received £60. (7) Heating account not recorded £70. (8) British Rail carriage charge not entered £20. (9) 50% of the Cash in Transit Premium is to be carried forward.

(1 0) Trading Stamps are issued at the rate of 2~% of Cash Sales. (11) Stocks of goods at month end are to be valued at cost. (12) Depreciation of fixed assets:

Premises, at rate of 5% p.a. Fittings, at rate of 10% p.a. (excluding purchases in month). Vehicles at rate of 25% p.a. (including purchases in month, excluding sale).

CHAPTER4

Financial Control

As a business grows in size and the proprietor becomes removed from the day-today working it becomes necessary to prepare the records in such a manner that control over the general operations of the organisation can still be maintained.

Reference to the previous chapter will show that the accounts of the individual debtors and creditors had in fact been removed from the general ledger and replaced by total or control accounts, on the basis that the proprietor may not be concerned with the operation of the individual accounts but will be more concerned with the overall state of the relationship between debtors and creditors balances in total. The responsibility for control of the individual accounts has been passed to another section. At the same time, with the routine work having been removed management is in a position to oversee the general situation and plan the strategy of the business, thus fulfilling its role as decisionmaker.

Control or total accounts have already been operated in respect of the various classes of Fixed Assets and their accumulated depreciation and also in the case of stocks.

The ledger accounts for Fixed Assets have indicated the total cost of each class without reference to the type of individual asset. Such information has been recorded in the Plant Register, a ledger containing a record of each individual piece of fixed asset by class, together with details of the annual and accumulated charge for depreciation. Periodically the amounts on the Plant Register are listed and agreed with the balances on the respective asset and depreciation accounts.

Differences between the balance on the control account and the individual Plant Registers are located and corrected, using the same technique as when agreeing the Trial Balance and Debtor and Creditor controls.

With regard to stocks, a record is maintained of the quantities and values of each type of stock on individual cards, these accounts forming the stores ledger. As required the balances are listed and the total agreed with the balance on the stock account.

When the business is converted to a limited company and the capital is subscribed by numerous individuals, the capital account balance will be represented by the balance in a ledger referred to as the Register of Members. This ledger, containing an account for each person who has placed funds in the

Financial Control 81

business, shows the amount subscribed. The individual balances are extracted when required and agreed with the balance on the control - the Share Capital Account.

Control or total accounts will be maintained in respect of Stocks despatched to Branches, in order that a check can be maintained on the selling prices and the general efficiency of the branch in regard to stock and cash control.

Examination questions on the control topic are generally confined to the preparation and correction of debtor and creiitor control accounts. The basic point concerning control or total account is: if an entry is made in the account of the individual debtor or creditor then an entry is also made in the total account; if the transaction does not require an entry in the debtor or creditor account then no entry is required in the total amount.

Opening Balance Sales on credit Cash Refunds

Cash Paid Discounts received Goods returned Contra items with debtors Balance c/d

Debtors Control Account

Cash received Discounts allowed Goods returned by customers Bills receivable Bad debts written off Contra items with creditors ledger Balance c/d

Creditors Control Account

Opening balance Cash refunds Goods purchased on credit

The control accounts act as a check on the accuracy of the posting of individual personal accounts and also allow overall financial control to be carried out without reference to individual accounts.

The purpose of total accounts is to control the operations of office staff operating the individual accounts, to segregate the routine work, to speed up the preparation of management information and to eliminate a considerable amount of the routine checking that is necessary when separate Sales and Purchases Ledgers have not been created. Where the Trial Balance on the General Ledger does not agree it would only be necessary to check the total postings to the control. It is only necessary to check the entries in the individual accounts when the totals of these balances do not agree with the balance on the control.

Types of Error Co"ections

(1) Sales summary overstated £100

(2) A debtor omitted £45

No effect on personal account. Cr. Control; Dr. Sales. The individual accounts were correctly posted. No adjustment to Control. Entries were correct. Add balance to list.


(3) Purchase invoice £80 not posted but included in summary total.

(4) Return by T. Smith £40 posted toT. Smithson.

(5) Cheque dishonoured £92 not entered in Cash Book.

(6) Sales invoice £180 posted to personal a/c as £108

(7) Purchase invoice summary £2,120 posted as £2.210 to Control.

No adjustment to Control. Total posting was correct. Add £80 to balance on creditors account. Adjust personal accounts only. This will not have created a difference. Will require an entry in debtors account and also in Control. Will not have been one of the reasons for a difference. No effect on Control. Total posting was correct. Add £72 to debtors balance. No adjustment to personal account. Invoices had been posted correctly. Dr. Control £90 purchases overstated.

The control accounts can be divided into smaller units for ease of administration, e.g. debtors A-J, K-N, 0-Z. From the following details prepare the control accounts:

At 1 April Creditors ledger balances Debtors ledger balances Provision for bad debts

Totals for April Sales invoices sent Purchases invoices received Returns to suppliers Returns from customers Allowances by suppliers Allowances to customers Bad debts written off Receipts for cash sales Bad debts previously written off, now recorded Interest charged on customer's overdue account Cash paid to suppliers Cash received from customers Cash discount allowed Cash discount received Dishonoured cheque included in total cash

received from customers (above) Cash discount which had been allowed on

dishonoured cheque (above) Payments to suppliers for cash purchases

3,282 8,884

177

10,322 9,389

528 280 89 23

254 987

18 3

9,325 9,873

89 183

98

2 1,231

Notes

2 3 4

3

Financifll Control 83

At 30 April Contra item: B. Jones is both a customer and a

supplier. In the purchases ledger he has a balance of £22 and in the sales ledger a balance of £56. A net balance is to be shown.

The account of A. Brown (a customer) has a credit balance of : 27

Provision for bad debts 250

5

6

The control account balance indicates the indebtedness of debtors or the amount due to creditors. In practice it is possible that amounts may be due by debtors as a result of overpayments and creditors may be due to make refunds.

Such balances will only be seen when the list of individual debtors and creditors is prepared. The balance on the control account will then be adjusted in order to show the gross value of debtors and creditors.

Balance 1 April Sales Invoices Interest on overdue

accounts Cheque dishonoured Cheque dishonoured,

discount disallowed Balance c/d

Balance b/d

Goods returned Discount received Cash paid Cash discount B. Jones Contra Balance c/d

Debtors Control

8,884 10,322 Goods returned

3 Discount allowed Bad debts written off

98 Cash received 2 Cash discount

B. Jones Contra 27 Balance c/d

£19,336

8,795 Balance b/d

Creditors Control

528 89

9,325 183 22

2,524

£12,671

Balance 1 April Purchase invoices

Balance c/d

280 23

254 9,873

89 22

8,795

£19,336

27

3,282 9,389

£12,671

2,524


Provision for Bad Debts

Debts written off 254 Balance 1 April Cash bad debts recovered

Balance c/d 250 Profit and Loss A/c

£504

Balance b/d

Notes:

I77 I8

309

£504

250

(I) Allowances to customers include such items as trade discounts on bulk purchase, whereas the cash discount is for prompt settlement of invoices, e.g. 2*% for payment within seven days of invoice.

(2) The bad debts are written off against the provision account. (3) Receipts for cash sales and payments for cash purchases do not affect the

debtors or creditors and are ignored in the control accounts. (4) The bad debt previously written off, now recovered, is credited to the

bad debt provision account. No adjustment in the debtors control is necessary as the particular customer's accounts had been written down to a nil balance.

(5) Where an individual is both a customer and a supplier it may be necessary to offset the indebtedness and leave the net balance in the appropriate account. In this case B. Jones is a debtor for £56- £22 = £34.

(6) Where credit balances appear on a debtors ledger and debit balances appear on a creditors ledger it is necessary to show the gross amounts of debtors and creditors on the Balance Sheet:

Branch Accounts

Creditors per Creditors ledger Creditors per Debtors ledger

Balance per Balance Sheet

2,524 27

£2,5SI

A firm which has branches either within the UK or abroad is faced with the problems of maintaining, management control, branch efficiency and profitability and stock security. These may be overcome by (I) maintaining records at the head office and either supplying goods at selling price or at cost price; (2) having the branch maintain its own set of books.

Goods supplied at selling price

Where goods are supplied to a branch at a price greater than cost it is necessary to create a provision for unrealised profit on stock at the branch which has not been sold. The entries for a non-accounting branch would be:

Dr. Branch Stock a/c Cr. H.O. Purchases Cr. Provision unrealised profit

The cost of the goods and the expected profit on sale


Cr. Branch Stock a/c Dr. Cash/Debtors, etc.

The value of goods sold

Dr. Provision for unrealised profit Cr. Profit and Loss a/c Profit on goods sold by the branch

Where several branches are operated the profit on goods sold could be credited to a specific branch account, whilst the branch expenses could be charged to that account; the resulting difference would be the profit or loss of the particular branch, which would be transferred to the main Profit and Loss Account. This method is useful where the head office wish to maintain strict control over the value of branch stock.

A firm has a branch and goods are invoiced at selling price which is cost plus 25%. All expenses are paid by the head office and the branch remits all cash received. A summary of the transactions are:

Stock 1 Jan. Sales Price Stock 31 Dec. Sales Price Debtors 1 Jan. Debtors 31 Dec. Cash sales for the year Credit Sales

12,500 15,000 7,000 9,000

54,000 35,000

Cash received from debtors Goods received from H.O. Rent Wages Sundry expenses

The accounts would appear as follows:

Branch Stock Account (Selling Price)

Balance 1 Jan. FromH.O. Difference transferred

to Branch a/c

Balance

12,500 91,000

500

£104,000

£15,000

Cash Sales Credit Sales

Balance 31 Dec.

Goods to Branch or H.O. Purchases Account (Cost)

Balance 1 Jan. Credit Sales

Balance

I Branch Stock

Branch Debtors

7,000 35,000

£42,000

9,000

Cash Balance 31 Dec.

33,000 91,000

4,000 3,400

800

54,000 35,000

15,000

£104,000

72,800

33,000 9,000

£42,000


Profit to Branch a/c

Balance 31 Dec. -+h- X 15 ,000

Wages Rent Sundry

Provision for Unrealised Profit

Balance 1 Jan. mx 12,500= 17,700 Branch Stock

-f,Ax 91,000=

3,000

£20,700

Balance

Branch Profit and Loss Account

Profit or Sales

Difference in Stock Profit to Profit and Loss a/c

4,000 3,400

800 10,000

£18,200

Notes:

2,500

18,200

£20,700

£3,000

17,700

500

£18,200

(1) There is a difference, on the stock control account, of £500 which should be investigated. This could be credited to a suspense account where inaccuracies of stocktaking are suspected, or credited to the Branch Profit and Loss Account where it has resulted from increased sales prices.

(2) The provision for unrealised profit is deducted from the Branch Stock to reduce it to cost on the Balance Sheet.

(3) The Goods to Branch Account, which is at cost, is transferred to the Head Office purchases or stock account.

Self-accounting Branches require a similar procedure to non-accounting branches with the exception that all transactions affecting th'e branch are recorded in a Branch Current Account in the Head Office books and a Head Office Current Account in the branch books. It is essential to ensure that the balances on the current accounts agree before the Profit and Loss Account and Balance Sheet of the firm are prepared. The Head Office Account in the branch books is the equivalent of the capital invested in it by the Head Office and represents the Fixed Assets, Current Assets and Liabilities of the Branch.

A company's head office is in London and it has a branch in Glasgow. All goods are purchased by the head office and invoiced to the branch at cost price plus 20%. The branch keeps its own complete set of books. The following are the Trial Balances as at 31 December:


London Glasgow

Land and Building at cost 84,528 24,380 Plant and Machinery at cost 57,367 18,273 Goodwill at cost 20,000 Stock at cost 22,431 Stock at invoiced price 12,840 Debtors 10,515 5,777 Balance at Bank 3,464 1,760 Current A/c with Branch 45,705

£244,010 £63,030

Share Capital 173,500 General Reserve 5,000 Creditors 4,137 1,131 Profit and Loss a/c I January 12,972 Depreciation to date Land and Buildings 1,954 1,246 Depreciation to date Plant 4,252 1,948 Provision for taxation 18,000 Profits for year 24,195 13,946 Current A/c with Head Office 44,759

£244,010 £63,030

Subject to the items mentioned below, and to the appropriation of profits, all the necessary closing entries have been made.

The difference between the cu.rrent accounts arises from (I) £400 remitted by the branch on 31 December which was not received by head office until 2 January; (2) £546 for goods invoiced and despatched to the branch by head office on 30 December which were not received by the branch until4 January.

Before the accounts can be prepared the Current Accounts must agree and it is necessary to make the following adjustments:

Head Office Trial Balance Dr. Cash in Transit Cr. Current Account

Branch Trial Balance Dr. Goods in Transit Cr. Current Account

400 400

546 546

The Head Office Current Account with the branch will be 45,705 - 400 =

£45,305. The Branch Current Account with the Head Office will be 44,759 + 546 =

£45,305. The stock which is held by the branch is valued at the invoice price which is

20% above cost price. A provision for unrealised profit must be created:


Dr. Head Office Profit and Loss a/c Cr. Provision for unrealised profit

& X £12,840 + 546 = £2,231

The Balance Sheet can be drawn up in the usual manner, combining both the head office and branch assets and liabilities.

Balance Sheet

Cost Depre-ciation

Land and Building 108,908 3,200 105,708 Plant and Machinery 75,640 6,200 69,440 Goodwill 20,000 Stock (22,431 + 12,840 + 546- 2,231) 33,586 Debtors 16,292 Cash (3,464 + I ,760 + 400) 5,624

55,502 Creditors 5,268 Taxation 18,000 23,268 32,234

£227,382

Share Capital 173,500 General Reserves 5,000 Profit and Loss Account I Jan. 12,972 Profit for Year 35,910 48,882

£227,382

The cash in transit and stock in transit (reduced to cost) could be shown as separate current assets if this is preferred.

Profit and Loss Account

Head Office Profit (24,195- 2,231) = Branch

Foreign Branches

21,964 13,946

£35,910

Where a foreign branch is self-accounting the Trial Balance of the branch is normally sent to Head Office but will be in the local currency; it will be necessary to convert the various amounts into sterling. The procedure which may be adopted is as follows:

(I) Ensure the current accounts agree, i.e. that there are no goods or cash, etc., in transit. The balance in the Head Office books will therefore equal the balance in Branch Trial Balance. No currency rate need be applied.


(2) Convert Fixed Assets and Depreciation at the rate in force at time of purchase or at the fixed rate the firm uses.

(3) Current assets and liabilities at the rate in force at the Balance Sheet date. (4) Remittances are converted at the actual rate received. (5) The difference on the converted Trial Balance is a difference arising on

exchange and this should be charged to the main Profit and Loss Account. It is not a loss chargeable to the foreign branch. An adjustment will be necessary in the current account in Head Office books.

(6) When considering the items which are included in the Profit and Loss Account either convert the income and expenses at an average rate for the period and calculate the profit or loss in sterling, or prepare the Profit and Loss Account in the local currency and convert the result at the fixed or average rate.

Hire Purchase Control

A further form of control arises when a trading company's activities consist of selling goods on an instalment basis. The company will create an account for each customer but will mainly be concerned with the total value of outstanding transactions and the extent to which profit should be taken in a financial period.

Under the terms of a Hire Purchase Agreement the goods are hired to the recipient and then at the end of the contract the title in the goods passes to the buyer, whereas under an agreement to pay by instalments (a credit sale) the title of the goods belongs to the recipient from the commencement of the agreement.

Most firms do not finance their hire purchase sales but sell the contract to a finance house. The regulations concerning hire purchase contracts are governed by various Hire Purchase Acts of which the 1964 and 1965 Acts are the most important.

Goods costing £6,000, where sold on a credit sale basis for £11 ,000, are settled by a deposit of £3,000 and the balance by four annual instalments of £2,000. The cash sale price for these goods would be £9,000.

Cash sale price Cost

Gross Profit Interest

Total profit

The entries would be: Dr. Customer Cr. Sales Dr. Cash Cr. Customer Dr. Cash Cr. Customer Dr. Customer Cr Profit and Loss

Account

9,000 The Profit could be taken as 6,000 A Gross Profit at point of sale plus interest

3,000 earned to date.

2,000 B Total Profit as% of cash received:

Cash price of goods

Deposit received

Instalments paid

Interest portion of each instalment


An alternative method of treatment is to take a portion of the total profit, i.e. the difference between the cost of goods sold and the total income expected, based on the actual cash received within the financial period. Using the same example as above:

£11,000 Total Income - £6,000 Cost = £5,000 Overall Profit and 2 instalments paid by end of financial year.

Profit to be taken is: Cash Received £7,000 _ Total Due £11 ,OOO x Profit £5,000- £3,182 approx.

The entries would be:

Dr. Customer Full amount of sale Cr. H.P. Trading a/c

Dr. H.P. Trading a/c Cost of goods sold Cr. Stock

Dr. Cash Cash received deposit Cr. Customer and instalment

Dr. H.P. Trading a/ c Proportion of profit earned Cr. Profit and loss a/c

The balance on the H.P. Trading Account is the amount of the outstanding profit not yet earned and is deducted from the debtors on the Balance Sheet.

Where an instalment is due but not yet paid the proportion of the profit applicable to such instalment is taken and the unpaid instalment shown as a debtor.

On 1 January P. Ltd. commenced business selling goods on hire purchase. Under the terms of the agreements an initial deposit of 20% is payable on delivery, followed by four equal quarterly instalments, the first being due three months after the date of sale. During the year sales were made as follows:

10 January 8 March 12 May 6July 20 September 15 October 21 November

Cost price(£)

150 350

90 200

70 190 160

H.P. Sales price ( £)

225 525 135 300 105 285 240


The goods sold in July were returned in September and eventually sold in November for £187 cash. All other instalments are paid on the due dates.

It may be assumed that: (A) gross profit and interest are credited to the Profit and Loss Account in the proportion that deposits and instalments received bear to hire purchase price; or (B) the cost is deemed to be paid in full before any credit is taken for gross profit and interest.

Wor

kin_

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Ass

umpt

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A A

B

c D

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(A-B

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~

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n. 1

0 15

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45

13

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15

30

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Mar

. 8

350

525

175

105

315

420

105

140

35

70

~ ...

May

12

90

135

45

27

54

81

54

27

18

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July

6

200

300

100

60

187

247

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57

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228

19

76

152

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160

240

80

48

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192

16

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;:;·

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1,81

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323

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B

(D-A

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10

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225

75

180

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30

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350

525

175

420

105

70

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-~-

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12

90

135

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81

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9

July

6

200

300

100

247

47

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70

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53

--


By using Assumption B a more prudent estimate of the profits earned results, since no profit is taken until the cost of goods sold has been recovered. Thereafter each instalment is 100% profit, whereas under assumption A part of the cost is recovered with every instalment and a proportion of the potential profit is also taken.

The asset on the Balance Sheet has been referred to as stock but under a credit sale agreement the asset would be debtors not yet due, because the title to the goods passed to the customer on the first payment and not on the last as in the case of hire purchase contracts. In the case of a credit sale agreement it may not be necessary to set up the provision for unrealised profit.

The main consideration concerning the purchaser is the treatment of interest on the money borrowed. One method of dealing with this is as follows:

Dr. Asset Account Cash price of item bought Cr. H.P. Company a/c

Dr. H.P. Company a/c Cash payments Cr. Cash Book

Dr. Interest paid a/c Interest element of each cash payment. This is Cr. H.P. Company a/c eventually written off to the Profit and Loss Account.

H.P. Ltd acquired three excavators from AB Ltd under a credit agreement, which provided for a deposit of 10% with the balance to be paid in three annual instalments, the first of which was due one year after signing the agreement and payment of the deposit. The date of purchase, capital cost and annual repayments are:

Excavator Date of Capital Annual Acquisition Cost Repayment

X 31 Dec. 19/-1 15,000 5,428 y 31 Dec. 19/-1 15,000 5,428 z 31 Dec. 19/-3 25,000 8,042

All instalments were paid on the due dates, except that when excavator Z was purchased the vendor agreed to take back excavator X on the basis that H.P. Ltd was to be credited with £5,000 in lieu of a deposit on excavator Z, and that a further payment, £5,100, was to be made in respect of excavator X with the instalment paid on 31 December.

The practice of H.P. Ltd was to capitalise the cash value of each excavator immediately on purchase, crediting it to the vendor. Each yearly instalment included interest at the rate of 10% per annum, calculated on the outstanding balance at the beginning of the year.

H.P. Ltd makes up its accounts to 31 December of each year and provides depreciation on excavators at the rate of 20% on reducing balance.

Exc

avat

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X

y z

' X

y

z 31

Dec

. 1

9-1

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15,0

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15,0

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Dis

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Dec

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Bal

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c/d

15

,000

25

,000

--

--

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25,0

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15,0

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15,0

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--

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Acc

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X

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--

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Ent

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Fix

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at c

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less

Pro

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20

£27,

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dis

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exc

avat

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to

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adm

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cost

s, e

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Dep

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n (R

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Bal

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Met

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Y

ear

1 C

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15,0

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Dep

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1,

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--

NB

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Financial Control 9 7

Questions 4.1 From such of the following year-end balances as are relevant, prepare sales

and purchases ledger control accounts: Opening Balance - Debtors

Creditors Purchases - On Credit

For Cash Sales - On Credit

For Cash Payment on account of Credit Purchases Receipts on account of Credit Sales Cash Discounts Received Cash Discounts Allowed Trade Discounts Allowed Returns Inwards Returns Outwards Contras between Debtors and Creditors Bad Debts written off during year Bad Debts Provisions - balance brought down Bills Receivable Received Bills Receivable Discounted Bills Receivable Dishonoured Bills Payable Met Bills Payable Issued

3,426 2,743

15,622 7,321

24,297 10,427 14,899 22,453

3I2 510

1I ,562 764 2I3 459

82 II 5 614 524 46

1,229 1,0I6

4.2 From the following particulars prepare the branch account as it would appear in the head office books. The branch sales are exclusively cash, and the goods sent to the branch have been invoiced at cost price:

Goods from head office 5,508 Returns to head office 42 Rates and Insurance paid 65 Wages paid 362 Cash remitted to H.O. 6,871 Stock I Jan. 816 Rent paid 140 Stock 31 Dec. 795 Sundry expenses paid 81

4.3 From the particulars given below, write up the branch account in the head office books. The branch sales are exclusively for cash and the goods sent to the branch have been invoiced at 33th% on cost:

Goods sent to branch 6 ,840 Wages paid 372 Cash remitted to H.O. 6,855 Stock 1 Jan. 920 Rates paid 80 Rent paid 145 Stock 31 Dec. 895 Sundry expenses 39


4.4 S.C. Ltd have a branch in Bristol. Goods are invoiced at selling price, being cost plus 25%. The branch keeps a sales ledger and remits all cash received to H.O. All expenses paid by H.O. Prepare a P and L a/c of the Bristol branch.

Stock 1 Jan. (Invoice Price) 1,250 Cash rec'd from Drs 3,300 Stock 31 Dec. " " 1,500 Goods invoiced from Drs. 1 Jan. 700 London 9,100 Drs. 31 Dec. 900 Rent 400 Cash Sales for year 5,400 Wages 340 Credit sales 3,500 Sundry expenses 80

4.5 The summarised balances of Summer Fashions Ltd trading in London on 1

4.6

January 19-- were: Fixed Assets 50,000 Stock IO,OOO Debtors 8,000 Cash 12,000 Creditors 20,000

(A) On 2 January two branches were opened, A and B, and £4,000 goods at cost were sent to each branch.

(B) On 3 January London Head Office makes purchases of £16,000. {C) On 4 January £4,000 goods sent to each branch. (D) On 7 January the following information was returned to H.O.

A B Remittances I1 ,500 9,000 Allowances made 200 300 Returns made I 50 350

Head office sales £I8,000; expenses paid £3,000, of which £I,OOO related to A and £800 to B.

(E) The value of assets transferred to each branch was recorded: (A) £20,000; (B) 15,000. The closing stocks were {A) £2,000; (B) £3,000; H.O. £1,000

The normal rate of gross profit is SO% on sales. Record the above transactions, show the branch profits and

prepare a statement to verify the valuation of stock.

S. Ltd opened an overseas branch in Kariba on 1 January. The following Trial Balance, in dollars, at 31 December has been received at Head Office:

Branch T.B. Gross Profit Selling Costs 40,000

30,000 IS,OOO IO,OOO 80,000 70,000

100,000

General office expenses Vehicle costs, 31 Mar. Office Equip. cost, I Jan. Stock Drs. and Crs. c/f 245,000

50,000 150,000


b/f 245,000 150,000

H.O. Remittances 1 Jan. 100,000 30 June 50,000 150,000

Cash at bank 55,000

$300,000 $300,000

Notes: (1) Depreciation is to be provided on cost of the fixed assets according to use at the rate of 5% on office equipment and 20% on vehicles. (2) Rates of exchange, for conversion, to sterling were:

1 Jan. 31 Mar. 30 June 30 Sept. 31 Dec. Average

5 6 5.5 5.5 5

$5.25

From the above information prepare the branch Trial Balance in sterling, incorporating depreciation, showing the rates of conversion.

4.7 A company with its head office in London operates an overseas branch. The branch books are kept in local currency, the florin. A.T.B. taken from the branch book at 31 December was:

Head Office a/c at 1 Jan. 152,636 Remittances 95,000 Fixtures and Fittings 7,687 Debtors 122,073 Stock 1 Jan. 23,465 Creditors 121,968 Purchases 168,350 Sales 192,581 Expenses 10,510 Cash 40,100

f.467,185 f.467,185

In the head office books the balance on the branch account at 1 January was £16,607 and the remittance account balance, 31 December was £9,661. There was no cash in transit. The branch stock was valued at £31 ,000 on 31 December.

Rates of exchange were:

1 Jan. 31 Dec. At purchase of F .A.

f 9.50 flO .SO fl0.25

= £1


Prepare the Trial Balance given conversion rates and show the profit or loss made by the branch. Show the journal entries in the H.O. books necessary to incorporate the results.

4.8 (a) On 1 September the totals of the sales and purchase ledger balances were:

Dr. Cr. Sales Ledger 4,926 31 Purchase Ledger 17 3,040

During September the sales on credit were totalled at £3,567 and the credit purchases amounted to £2,784; returns were, sales £154 and purchases £67; bad debts of £83 were written off; a debtor for £36 was settled by contra with the purchase ledger credit balance for the same person. The analysis columns of the cash book for September contained the following totals:

Debit side- sales ledger £4,100, discounts £186 Credit side -purchase ledger £2,872, discounts £75

At 30 September credit balances in the sales ledger totalled £17 and there were debit balances in the purchase ledger amounting to £24. You are required to prepare the sales ledger control account and the purchase ledger control account for September and bring down the balances to 1 October. (b) After the control accounts in (a) above had been prepared it was found

that: (i) goods sold to B. Brown had been correctly invoiced at £72 but wrongly

recorded in the books as £27; (ii) the purchase of goods for £36 from C. Castle had been completely

omitted from the records; (iii) The sales returns for the month had been undercast by £10 and dis

counts allowed had been overcast in the cash book by the same amount.

You are required to: (i) prepare the journal entries necessary to rectify the errors and omissions

(narrations are not required); (ii) submit your calculation of the corrected totals of debtors in the sales

ledger and creditors in the purchase ledger at 30 September.

4.9 The following figures were extracted from a trader's books: Debit balance on sales ledger control a/c 1 Jan. 5,082 Sales, per sales journal in year 61,318 Discounts allowed per cash book 1 ,437 Receipts on account of credit sales 58,946

The book-keeper prepared a list of the sales ledger balances and these amounted to £5,502. The following errors were later discovered: (1) The sales journal had been overcast by £90. (2) The debit side of the personal a/c of a customer had been undercast by

£209. (3) Discounts allowed £48 had been credited to the personal a/c's but no

other entries had been made.


(4) Goods £16 had been returned by a customer but no entry had been made anywhere in the books.

(5) A sales invoice £132 entered in the sales journal had not been posted to the customer's a/c.

(6) A debit balance of £36 on a customer's a/chad been omitted from the list of balances.

After the discovery of the above errors the book-keeper prepared a sales ledger control account and revised list of balances at 31 December. You are required to:

(i) show the sales ledger control account; (ii) show your calculation of the total of the revised list of the sales ledger

balances.

4.10 The following balances were extracted from the books as on 31 December:

Total of sales ledger balances £12,716 Total of purchases ledger balances 8,270 Balances on sales ledger control account 12,865 Balances on purchases ledger control account 8,301

The balances on the control accounts mentioned above were included in the Trial Balance extracted as on 31 December. In this Trial Balance, the total of the debit balances exceeded the total of the credit balances by £359.

The following errors were afterwards discovered: (I) The sales journal for the month of December was correctly totalled as

£6,412 but this was incorrectly posted to the credit of the sales account as £6,142.

(2) Discount of £35 allowed by a supplier had been entered on the wrong side of his personal account in the purchase ledger.

(3) The purchases journal for the month of December had been overcast by £190.

(4) A debit balance of £71 on the personal account of a customer had been omitted from the list of sales ledger balances.

(5) During December it was decided that a debt of £78 owing by a customer should be written off as bad. The correct entry was made in the debtor's personal account in the sales ledger, but no other entries had been made in the books.

After the above errors had been discovered, an undetected error remained in the company's books. You are required to:

(i) prepare a statement showing the revised totals of the sales and purchases ledger balances and the revised balance on each of the control accounts, on the assumption that the errors mentioned above had been corrected;

(ii) calculate the amount of the undetected error and give your opinion of its location in the books.

CHAPTER 5

Incomplete Records

Before studying the problem of incomplete records it is essential to remember the elementary accounting principles, which are as follows:

(1) That every transaction is recorded in some suitable form, i.e. by means of journal entry, proof sheet, original document, in order that the item can be entered in the relevant account.

(2) That every transaction involves a dual movement of the business funds (a double entry has been made, i.e. each debit has a corresponding credit).

(3) That the control of debtors and creditors is maintained by the use of summary accounts.

Many traders, however, think it unnecessary to maintain accounts in order to ascertain the results of their operations, either because they lack understanding of the book-keeping system or because they think the size of the business does not warrant a full set of books.

The results of a period's trading will, however, be required by the Inland Revenue for taxation purposes and an accountant may then be approached with a request to complete a set of trading accounts from the few records kept by the trader. These records may be nothing more than copies of unpaid invoices relating to suppliers and customers, all other invoices having been destroyed at the time of payment as the trader saw no need to retain paid invoices.

The trader should, however, have a copy of his Balance Sheet at the end of the previous financial period, giving details of the assets and liabilities of the business. He will also be able to provide an estimate of his position at the end of the financial period. From this information it will be possible to calculate approximately his profit or loss for the period, because profits earned are reflected in an increase in the proprietor's interest. This point can be illustrated by the following example.

A trader commenced business on 1 January with a capital of £29,000. He says that at 31 December his position was: Premises, £20,000; Shop Fittings, £6,000; Stock, £3,000; Debtors, £5,000: Bank £3,700 and Creditors, £4,600. A Balance Sheet at 31 December would show:

Incomplete Records 103

Premises 20,000 Fittings 6,000 Stock 3,000 Debtors 5,000 Bank 3,700

37,700 Less Creditors 4,600

:. Proprietor's Interest £33,IOO

The increase in proprietor's interest must be represented by profit in the absence of other information, e.g.:

Proprietor's Interest I January Proprietor's Interest 3I December Increase due to Profits earned in

period

29,000 33,IOO

£4,IOO

This method of arriving at a profit, however, may be inconclusive or incorrect because the trader may have concealed various factors in the belief that they are not essential to the calculation of profit. At the same time, even if all information is provided certain movements will take place in a business which will not produce a profit or loss; these will include: (I) introduction and withdrawal of Assets by Proprietor; (2) purchase of Assets from funds other than those already in the business; (3) loss in value of Assets through depreciation or obsolescence; (4) sale of Assets at a figure other than their book value.

These points can best be illustrated by an example:

1 Jan. 31 Dec.

Premises 25,000 35,000 Fittings 12,000 10,000 Stock 8,000 6,500 Debtors 9,000 10,500 Bank 3,000 4,900

57,000 66,900 Less Creditors 7,500 8,700

Proprietor's Interest £49,500 £58,200

The trader says that he has withdrawn £50 per week from takings and taken £300 of goods during the year. During the year he sold some private investments and used the proceeds, £10,000, to purchase additional premises. He had also allowed £2,000 as depreciation on Fittings.

In calculating profit the following must be borne in mind: (I) if cash had not been withheld the bank balance would be £2,600 (£50 x 52 weeks) greater than shown; (2) if stock of £300 had not been taken by proprietor the Balance Sheet


at 31 December would show stock as £6,800; (3) the purchase of premises would not have been possible without introduction of additional funds.

If the proprietor had not carried out the transactions mentioned above the Balance Sheet as at 31 December would have appeared as follows:

Premises (£35,000- £10,000) 25,000 Fittings 10,000 Stock (£6,500 + £300) 6,800 Debtors 10,500 Bank (£4,900 + £2,600) 7,500

Less Creditors


Profit would be calculated as follows: Proprietor's Interest at 1 January Proprietor's Interest at 31 December

Apparent Profit after Deprecation

This profit can be proved in the following manner: Proprietor's Interest 1 January Proprietor's Interest 31 December

(as per original summary)

Apparent Profit Add Assets Withdrawn:

Stocks Cash

Deduct Funds Introduced:

:. Actual Profit

300 2,600

59,800 8,700

£51,100

49,500 51,100

£1,600

49,500 58,200

8,700

2,900 11,600 10,000

£1,600

The trader's Balance Sheet at 31 December can now be drawn up as follows: Premises at 1 January 25,000 Additions in Period 10,000

Fittings at 1 January Less Depreciation

Stock Debtors Bank

Less Creditors

Net Assets

12,000 2,000

6,500 10,500 4,900

35,000

10,000

21,900

66,900 8,700

£58,200

Proprietor's Interest I January Add Capital Introduced Profits Earned in Period

Less Drawings


49,500 IO,OOO I ,600

6I ,IOO 2,900

£58,200

Note: The total of the above Balance Sheet corresponds to the original position provided by the trader, but we can now see in greater detail the state of the business and the movements of the proprietor's interest.

The following example should be studied:

1 Jan. 31 Dec.

Premises 10,000 15,000 Fittings 5,000 7,000 Vehicles 4,000 3,000 Stock 7,000 8,000 Debtors 9,000 10,000 Bank 3,000 4,000

38,000 47,000 Less Creditors 18,000 22,000

Proprietor's Interest £20,000 £25,000

The trader supplied the following information: He had surrendered a private insurance policy and used the proceeds to

purchase additional premises. Fittings at a cost of £3,000 had been purchased from business funds. £1,000

of the total of all fittings was to be charged for depreciation. The reduction in the value of vehicles was represented by depreciation. The trader has used £500 of stock for his private consumption and had also

withdrawn £3,000 in cash during the year. His position at 31 December would be calculated as follows:

Interest at I January Interest at 31 December Apparent Profit Add Assets Withdrawn

Stock Cash

Less Funds Introduced

Actual Profits

500 3,000

20,000 25,000

5,000

3,500

8,500 5,000

£3,500

It will be seen, if reference is made to the previous example, that there is no need to show depreciation in the above calculation.

The trader's Balance Sheet at 31 December would be shown as:


Premises at 1 January Additions

Fittings at 1 January Additions

Less Depreciation

Vehicles at 1 January Less Depreciation

Stocks Debtors Bank

Less Creditors

Net Assets

Proprietor's Interest at 1 January Capital Introduced Profit

Deduct Funds withdrawn

Proprietor's Interest at 31 December

10,000 5,000

5,000 3,000

8,000 1,000

4,000 1,000

8,000 10,000 4,000

15,000

7,000

3,000

25,000

22,000

47,000 22,000

£25,000

20,000 5,000 3,500

28,500 3,500

£25,000

The addition to Fittings, £3,000, has come from business funds and is merely an internal movement of assets.

Existence of Partial Records

The trader may have maintained a record of his receipts and payments - a summary of amounts paid into his bank accounts and counterfoils of cheques drawn. From these it is possible to prepare a Cash Account showing the trader's funds at the bank and his Cash in Hand.

The Trader's bank statements supplied by his bank must also be examined to discover receipts and payments recorded by the bank and not entered by the trader in his cash book, e.g. the receipt of monies direct from customers (Trader's Credits) and the payment of Standing Orders and Bank Charges.

Care must be taken during this operation to distinguish between business and personal transactions. The latter affect the proprietor's interest only and are not business income or expenses.


Although the trader has maintained a cash book, or had one prepared for him, no ledger accounts will have been written up and the single entry in the bank book must be converted to double entry by means of summary accounts.

Since personal accounts contain the basic facts shown below, the provision of a combination of any of them will enable the account to be completed.

Opening balance b/d Sales in period

Balance b/d

Cash Paid Closing Balance c/d

X X

Debtors Account

Cash Received Closing Balance c/d

Creditors Account

X X

Opening Balance b/d Purchases in period

Balance b/d

X X

X X

Thus if a trader provides the information that debtors at commencement of a fmancial period were £10,000, that he had received £35,000 in cash and that £12,000 was due at the end of the year, the value of sales could be calculated as follows:

Opening balance b/d :. Sales (calculated as)

Balance b/d

Debtors Account

10,000 37,000

£47,000

12,000

Cash Received Closing Balance c/d

35,000 12,000

£47,000

Similarly the value of purchases can be calculated, given that £7,500 was owed to creditors at commencement of the year, that £28,000 had been paid to them and that they were owed £9,800 at end of year. Preparation of a creditors control would proceed as follows:

Cash Paid Closing Balance c/d

Creditors Account

28,000 9,800

£37,800

Opening Balance b/d :. Purchases (calculated

as)

Closing Balance b/d

7,500

30,300

£37,800

9,800


Where the trader provides additional information, such as bad debts incurred, discounts allowed or received or cheques dishonoured, these appear as part of the double-entry system in the summary account. Given the information shown below in respect of debtors, sales would be calculated as indicated in the Debtors Account: Opening Balance Cash Received Cheques Dishonoured Bad Debts Written off Discounts Allowed Closing Balance

Opening Balance Cheques Dishonoureu

:. Sales

Closing Balance b/d

36,000 182,000

530 1,870 3,700

42,500

Debtors Account

36,000 530

36,530 193,540

£230,070

42,500

Cash Received Discounts- P and L a/c

Bad Debts - P and L a/c Closing Balance c/d

182,000 3,700

1,870 42,500

£230,070

The principles involved in preparing a set of accounts in accordance with the points demonstrated above can be followed by working through the following example.

A trader produces a summary of his bank book together with details of assets and liabilities at commencement and end of period:

Bank Book Summary, Year Ending 31 December

Opening Balance 1,125 Payments to Creditors 33,000 for Goods

Cash Sales 45,000 Cash Purchases 2,850 Receipts from Debtors 1,800 Rent 2,100 Closing Balance c/d 455 General Expenses 6,290

Cash Withdrawn by 4,140 Proprietor

£48,380 £48,380

Other Balances 1 Jan. 31 Dec.

Shop Fittings 1,500 1,200 Stock 4,740 5,130 Debtors 1,925 2,525 Rent Paid in Advance 300 Rent in Arrears 450 General Expenses in

Arrears 420 600 Creditors - Trade 3,750 3,375

Incomplete Records I 09

The trader says that prior to banking the takings he had paid wages £2,280 and had taken £400 for his own use. He had also taken goods £750 for his personal use. In addition he had allowed discounts of £785 and had written off Bad Debts of £150. Creditors had allowed him discounts of £450. The trader asks for a statement of profit for the year.

We can answer this problem in two ways - by the preparation of a closing Balance Sheet and the preparation of a Trading and Profit and Loss Account.

(I) Calculation of Proprietor's Interests:

Assets I Jan. 3I Dec.

Fittings 1,500 1,200 Stock 4,740 5,130 Debtors 1,925 2,525 Bank 1,125 Rent in Advance 300

9,290 9,155 Liabilities

Creditors 3,750 3,375 Expenses Outstanding 420 600 Rent Outstanding 450 Bank Overdraft 455

4,620 4,430 -- --

:. Proprietor's Interest £4,670 £4,725

Apparent profit represented by the increase 55

To which must be added: Drawings Cash (4,140 + 400) 4,540 Goods 750

--Actual Profit £5,345

(2) Calculation of the profit by Trading and Profit and Loss Account involves the following calculations:

Purchases on Credit

Cash Paid Discounts (P and L a/c) Closing Balance c/d

Creditors Account

33,000 450

3,375

£36,825

Opening Balance b/d :. Purchases (Cost of Sales a/c)

3,750 33,075

£36,825


Cost of Sales Account

Opening Stock b/d 4,740 Goods used by Prop. 750 Credit Purchases 33,075 Closing Stock c/ d 5,130 Cash Purchases per CB 2,850 :. Cost of Goods Sold 34,785

(Trading a/c)

£40,665 £40,665

Proprietor's Drawings Account

Goods 750 Transfer to Cap. a/c 5,290 Cash 4,140 Cash Prior to Bankings (Sales a/c) 400

£5,290 £5,290

Debtors Accounts

Opening Balance b/d 1,925 Cash Received 1,800 :. Credit Sales 3,335 Discounts (P and L a/c) 785

Bad Debts (P and L a/c) 150 Closing Balance c/d 2,525

£5,260 £5,260

Balance b/d 2,525

Sales Account

Trading a/c 51,015 Credit Sales 3,335 Cash Sales Banked 45,000 Cash Sales Withheld by 400

Prop. (Capital a/c) Cash Sales Used to 2,280

Pay Wages (P and L a/c)

£51,015 £51,015

Rent Account

Cash Paid 2,100 Balance b/d 450 (Arrears)

Balance c/d (Prepaymt.) 300 :. Profit and Loss ajc

Charge 1,350

£2,100 £2,100

Balance b/d 300


Expense Account

Cash Paid Balance c/f (Arrears)

6,290 600

£6,890

Balance b/d (Accrual) :. Charge for Year

(P and L a/c)

Balance b/d

Wages Account

Cash Paid £2,280 Profit and Loss a/c Charge

Trading and Profit and Loss Account for the Year Ending 31 December

Cost of Goods sold 34,785 Sales Gross Profit 16,230

Wages Rent General Expenses Discounts (785 - 450) Bad Debts Depreciation - Fittings

£51,015

2,280 1,350 6,470

335 150

(1 ,500 - 1 ,200) 300

Net Profit 10,885 5,345

£16,230

Gross Profit

420 6,470

£6,890

600

£2,280

51,015

£51,015

16,230

£16,230



Fittings Less Depreciation

Stock 5,130 Debtors 2,525 Rent Paid in Advance 300

Less Creditors 3,375 Accrued Charges 600 Bank Overdraft 455

Proprietor's Interest 1 Jan. Add Profit Earned

Less Drawings

Proprietor's Interest 31 Dec.

7,955

4,430

1,500 300

1,200

3,525

£4,725

4,670 5,345

10,015 5,290

£4,725

As with the summary of Debtors and Creditors, a Trading Account can be prepared to ascertain an unknown figure, i.e. Sales, Closing Stock, Gross Profit, Cost of Sales.

The following shows the layout of a Trading Account:

Trading Account

Opening Stock b/d Add Purchases

X Sales X

X Less Closing Stock c/f X

Cost of Goods Sold X Gross Profit c/d X

X

X

X

Sometimes it may be impossible to calculate sales because of the lack of information, e.g. records destroyed by fire. The Gross Profit margin expressed as a percentage will, however, be known, and from this information the Trading Account can be constructed as follows:

Assume no opening or closing stock Purchases are £50 ,000. Gross Profit is 25% on cost; this is £12,500. Therefore Sales are £62,500.


Trading Account

Purchases 50,000 Sales 62,500 Gross Profit @ 25% of cost 12,500

£62,500 £62,500

Assume: Purchases 90,000 Closing Stock 10,000

Cost of Goods Sold 80,000 If G.P. is 20% of cost, this is 16,000

:. Sales are 96,000

Trading Account

Purchases 90,000 Sales 96,000 Less Closing Stock 10,000

Cost of Goods Sold 80,000 Gross Profit @ 20% on Cost 16,000

£96,000 £96,000

Similarly, where the Sales figure is known but complete details of costs are not known (e.g. loss of stock as the result of a fire) the value of closing stock can be computed as follows:

Given that Opening Stock Purchases Sales Gross Profit 25% of sales

Calculate Closing Stock

Sales Gross Profit

:. Cost of Goods Sold Purchases + Opening Stock

:. Closing Stock

12,000 90,000

120,000

120,000 30,000

90,000 102,000

£12,000


Opening Stock Purchases

Closing Stock

Cost of Goods Sold Gross Profit

Trading Account

12,000 Sales 90,000

102,000 12,000

90,000 30,000

£120,000

Incomplete Records for Non-Trading Organisations

120,000

£120,000

There are also non-trading organisations who do not maintain full accounting records because there is no legal requirement for them to do so.

Such organisations, for example sporting clubs, horticultural societies, consumer protection associations, friendly societies, professional societies, would appoint a treasurer who would be expected to report, at least annually, the organisation's revenue and expenses.

Non-trading or voluntary societies will not obtain their initial funds in the form of capital, because the absence of initial formation expenses and capital equipment makes it unnecessary. When individuals decide to form a society they fix an annual subscription charge payable in advance by members and expenditure must be kept within this total income. To that extent a certain amount of budgeting is essential by voluntary organisations, added to which will be the necessity to find alternative methods of raising funds where it is obvious that expenditure will exceed income in a particular period. Such additional funds might consist of:

(1) Joining or entrance fees - a lump sum payable on admission in addition to first year's subscription. Such fees may be taken as Income in the period in which received or apportioned over a specified number of periods.

(2) Proceeds of raffles, competition tickets, dances, etc. The committee should ensure that revenue exceeds cost of prizes.

(3) Donations from supporters, other than members. (4) Profits from trading sections, e.g. restaurants and magazines.

The expenditure on the various activities and the day-to-day running of the society together with details of revenue, are recorded by the treasurer in the bank book, the record probably being maintained in an analytical manner to assist the treasurer in the preparation of a financial statement for the members at the end of the fmancial period. This summary of revenue and expenditure is referred to as a Receipts and Payments Account.

If it is assumed that a society is formed for the purpose of improving the safety of motor vehicles and during the first year recruits 10,000 members, each paying a £1 annual subscription, and the society makes revenue payments totalling £7,800, the difference between receipts and payments of £2,200 represents an excess of income over expenditure and would be placed in an

Incomplete Records I 15

Accumulated Fund, the name given to an account corresponding to the proprietor's interest of a trading concern.

The accumulated fund represents the accumulation of excesses of Income over Expenditure of the society during its existence and at the same time represents the difference between the Assets and liabilities of the society at any time.

It is important, however, that as with trading organisations a distinction is drawn between expenditure of a revenue nature and that of a capital nature. Assuming that the Society for Vehicle Safety incurred a cost of £2,000 in addition to the £7,800 indicated above on Vehicle Testing Equipment the Receipts and Payment Account would appear as follows:

Subscriptions

Receipts and Payments

10,000

£10,000

Printing and Stationery Telephone Rent of Premises Lecture Fees Secretary's Fees Equipment Balance c/d

2,500 1,000 1,500 1,800 1,000 2,000

200

£10,000

Whilst this account shows the members the state of their bank account it does not show them that subscriptions covered revenue expenditure, or the net assets of their society.

An Income and Expenditure Account (corresponding to the Profit and Loss Account of a trading concern) and a Balance Sheet are necessary for this.

Income and Expenditure Account of the Society for Vehicle Safety for the year ending 31 December

Expenditure

Printing Telephone Rent Fees Secretary

Excess of Income over Expenditure

2,500 1,000 1,500 1,800 1,000

7,800 2,200

£10,000

Income

Subscriptions 10,000

£10,000


Balance Sheet of the Society for Vehicle Safety as at 31 December

Assets Testing Equipment Bank

Accumulated Fund

2,000 200

£2,200

£2,200

Note that the Accumulated Fund equals assets -if these are realised at their Balance Sheet values the proceeds will revert to the members.

Subscriptions in Arrears or in Advance

like trading concerns, non-trading organisations are entitled to include as revenue any items due, or charged, to members in a particular year. At the same time they should exclude any revenue received relating to a subsequent year.

If it is assumed that during its second year the society, which has now increased to 12,000 members, has received £12,800 in subscriptions it would be correct to assume that 800 members had paid the following year's subscriptions. These would be carried forward to the Balance Sheet as liabilities, and the Income and Expenditure Account credited with £12,000. If, however, the treasurer informs the society that 1,000 members have paid in advance, the position would be as follows:

Subscription Account

Payments in Advance c/f 1,000 Cash Received 12,800 Income and Expenditure a/c 12,000 :. Subscriptions in

Arrears c/f 200

£13,000 £13,000

Arrears b/d 200 Prepayments b/d 1,000

The arrears are debtors to the society, i.e. members who owe for the services they have received; the prepayments are creditors, i.e. members who have not received any service for their subscriptions and would be entitled to a refund if their membership was cancelled or the society closed down.

Some organisations will not take subscriptions in arrears into account in the period to which they refer. They consider it better to adopt a conservative policy and only take the arrears into account in the financial period in which they are actually received.

Non-Trading Organisations Undertaking Trading Activities

Some voluntary organisations provide facilities for their members in the form of a restaurant, bar or magazine sales which it is hoped will result in a profit mainly to ensure that subscriptions are kept to a minimum.

Incomplete Records 11 7

The cost of running such activities will be set against the revenue earned from sales, the profit being shown by way of a Trading Account and subsequently shown as revenue in the Income and Expenditure Account.

Assuming that the society treasurer produced the following Receipts and Payments at the end of the second year and that the Subscription Account is as shown above, the accounts would be presented as:

Receipts and Payments, Year Ending 31 December- Year 2

Balance b/d 200 Printing Subscriptions 12,800 Telephone Bar Sales 3,500 Rent

£16,500

Lecture Fees Secretary's Fee Equipment Cost of Bar Supplies Balance c/d

3,000 1,200 1,500 1,800 1,000

500 2,625 4,875

£16,500

The treasurer has recommended that £700 be written off the value of equipment.

Bar Trading Account for the Period Ending 31 December

Cost of Supplies Profit

Printing Telephone Rent Lectures Secretary Depn. of Equipment


2,625 875

£3,500

Sales

Income and Expenditure Account for the Period Ending 31 December

3,000 1,200 1,500 1,800 1,000

700

9,200

3,675

£12,875

Subscriptions Profit on Bar

3,500

£3,500

12,000 875

£12,875



Assets

Testing Equipment at Cost Less Depreciation

Subscriptions in Arrears Bank

Less Subscriptions in Advance

Accumulated Fund 1 Jan.

2,500 700

200 4,875

5,075 1,000

Add Excess of Income over Expenditure for the year

Balance 31 Dec.

1,800

4,075

£5,875

2,200 3,675

£5,875

The above example assumes there was no closing stock. Where the organisation is carrying stock at the end of a fmancial year this will be dealt with in exactly the same manner as for a trading organisation, i.e. deduct the value of closing stock from purchases and show it as an asset on the Balance Sheet.

Income of a Special Nature, e.g. Prize Funds

Most professional bodies and, in some circumstances, research societies, award annual prizes for outstanding work by members. Such prizes will be awarded from the proceeds of the investment of funds which will probably have been donated by members on the understanding that the capital sum will be invested and the interest earned used only to donate prizes of a specific value.

Any unused revenue on the Prize Fund would be carried forward on the Balance Sheet for use in subsequent years. The accounting entries would be:

Receipt of Legacy

Purchase of Investment

Receipt of Interest on Investment

Payment of Prize Money

Dr. Bank Cr. Endowment

Dr. Investment Cr. Bank

Dr. Bank Cr. Prize Fund

Dr. Prize Fund Cr. Bank

Assume that a member, H.J. Smith, leaves a legacy to his association on condition that it is invested at 8% and the interest then used for the awarding of prizes. The prizes cost £650. The accounting entries would be as follows:

Incomplete Records Jl9

Bank Account

1 Jan. Receipt of Legacy 10,000 1 Jan. Purchase of Investmts. (H.J. Smith)

31 Dec. Investment Income 800 31 Dec. Prizes, cost of Balance c/d

Cost of Prizes for year Balance c/d

Investment

£10,800

H.J. Smith Endowment afc

I Cash

H.J. Smith Prize Fund

6SO ISO

£800

Interst for year

Balance b/d

8%Bond afc

10.000 1

10,000

6SO ISO

£10,800

10,000

800

£800

ISO

The balances on both the Legacy Account and the 8% Bonds Account will appear on the Balance Sheet.

Assuming that a member of the Vehicle Safety Society, Jones, died and left £S ,000 in his will in order to provide an award for the best safety device of the year, the Receipts and Payments Accourit for the third year of the society would be as follows:

Receipts and Payment for the Year Ending 31 December- Year 3

Balance b/f Subscriptions Bar Sales Legacy Investment Interest

4,87S 14,000 4,SOO s,ooo

400

£28,77S

Printing Rent Lecture Fees Secretary Equipment Telephone Cost of Bar Supplies Purchase of Investments Annual Safety Award Balance c/f

s,ooo l,SOO 2,200 l,SOO

300 1,600 3,87S s,ooo

37S 7,42S

£28,77S


The treasurer informs you that: (1) the society has 13,700 members and that 400 members are in arrears; (2) bar stocks are valued at £500; (3) £700 is to be written off equipment.

Balance b/d Income -Expenditure a/c :.Prepayments c/f

Balance b/d

Awards Balance c/d

Subs afc

200 Balance b/d 13,700 Cash

I ,500 Arrears c/f

£15,400

400 Balance b/d

Prize Fund

375 25

£400

Interest

Balance b/d

Bar Trading Account for the Year Ending 31 December

Purchases of Bar Supplies Less Stock

Profit

3,875 500

3,375 1,125

£4,500

Bar Sales

Income and Expenditure Account for the Year Ending 31 December

Printing Rent Lectures Secretary Telephone Depreciation


5,000 1,500 2,200 1,500 1,600

700

12,500 2,325

£14,825

Subscriptions Bar Profit

1,000 14,000

400

£15,400

1,500

400

£400

25

4,500

£4,500

13,700 1,125

£14,825



Equipment at Cost Less Depreciation

Investments F. Jones' Legacy Stocks Subs in Arrears Bank

Subs in Advance Prize Fund Legacy F. Jones

Accumulated Fund b/f 1 Jan. Add Excess of Income over

Expenditure for Year

Balance 31 Dec.

1,500 25

5,000

2,800 1,400

5,000 500 400

7,425

13,325

6,525

5,875

2,325

1,400

6,800

£8,200

8,200

The accumulated fund still represents the excess of the assets over the liabilities.

In examination questions candidates will often be required to calculate the accumulated fund at the commencement of a year. It is important to remember that the procedure is exactly the same as for ascertaining the interest of a sole trader:

Sole Trader

Assets - liabilities = Proprietor's Interest

Non- Trading Concerns

Assets - Liabilities = Accumulated Fund

In a similar manner to sole traders the information concerning Purchases and Sales may be presented in a manner that will necessitate the preparation of summary accounts to ascertain the cost of goods purchased and sales revenue.

Questions

5.1 A trader commenced business on 1 January with capital of £5,000. During the next twelve months he kept no books of account but at 31 December he informed his accountant that the business has the following assets and liabilities: Shop Fittings £4,750; Stock £3,500; Van £2,300; Debtors £3,200; Cash in Hand £225; Bank Overdraft £370; Creditors £2,850.

Calculate for the trader: (a) his capital at end of year; (b) his profit for the year.


5.2 A trader produced the following lists of assets and liabilities at I January and 3I December and informed his accountant that during the year he had paid into the business £4,500, the proceeds from the sale of private investments, and that he had withdrawn £3,700 of the profits earned in the year.

1 Jan. 31 Dec.

Fittings 3,500 3,300 Vehicles I,280 I ,IOO Stock 2,650 3,750 Debtors 750 900 Prepaid Expenses I20 ISO Accrued Expenses 70 90 Creditors I,950 I ,I70 Overdrafts I80 540

Prepare statements showing capital at I January and 3I December and indicate the profit earned in the year.

5.3 From the information provided below you are required to prepare a Trading and Profit and Loss Account for the year and a Balance Sheet as at 3I December.

Receipts Balance b/f Cash Sales Credit Sales Rent received

Summary of Bank Book

2,450 60,130

I,I20 250

£63,950

Payments Creditors Wages General Expenses Dishonoured Cheques Fittings - Shop Drawings Balance c/d

50,210 3,780 4,360

IS I,SOO

945 3,I40

£63,950

Additional information provided: (a) discounts allowed £250; (b) bad debts written off £75; (c) goods taken by proprietor £480.

Assets and Liabilities are:

1 Jan. 31 Dec.

Shop Fittings 8,500 9,300 Stock 4,600 4,950 Debtors 90 I25 Petty Cash in Hand 50 35 Creditors 3,750 4,290 Wages Accrued 480 570


5.4 From the following information calculate the accumulated fund of the Accounting Society as at 1 January: Bank Balance £4,500; Amounts due to Suppliers £750; Subscriptions in Arrears £380; Equipment as Valued £7 ,900; Investments £18,000; Subscriptions in Advance £250; Rent Accrued £690; Salaries due £1 ,470; Legacy £18,000; Prize Fund £120.

5.5 From the following Receipts and Payments Account, together with the additional information provided, prepare an Income and Expenditure Account for the year and a Balance Sheet as at the end of the year.

Balance b/f Subscriptions Donations Bar Sales Legacy Investment Income

Receipts and Payments afc

350 5,000

30 380

3,000 240

£9,000

Payments to Suppliers Printing Investments Telephone Postage Equipment Annual Awards Balance c/f

290 1,200 3,000

540 380 590 210

2,790

£9,000

The treasurer informs you that the society has 480 members each paying a £10 annual subscription:

1 Jan. 31 Dec. Creditors 70 85 Stocks 120 150 Subs in Arrears 90 20 Subs in Advance 40 ? Equipment 2,500 2,490 Prize Fund ?

CHAPTER 6

The Partnership

One form of organisational structure of a business is the partnership which occurs where two or more people carry on a business in common with the intention of earning profits. No particular formality is necessary to create a partnership but it is usual for an agreement, either verbal or written, to be made. Even if there is no agreement, where two people act as if they were in partnership they incur legal recognition as if a partnership existed and enjoy the benefits and incur the liabilities which that entails. Following are. some of the reasons for the formation of a partnership:

(1) Pooling of resources. A sole proprietor, having exhausted all his available sources of finance, will be unable to expand his business. The pooling of his own resources with one or more other individuals will provide the finance with which to expand.

(2) Complimentary expertise. Where the business requires expert knowledge it may be convenient for one partner to specialise in a particular area. For example, a partner in an accountancy practice may specialise in liquidations while another specialises in taxation.

(3) Economic advantages. Where there are several individuals carrying on similar work there may be economic advantages of scale, such as the reduction in administration or overhead costs.

(4) Provision of a service. Where the business is one in which it is essential to provide a continuous service it may be convenient to form a partnership which can evenly spread the workload, e.g. a medical or veterinary practice.

Different Kinds of Partner

There are four different kinds of partner: (1) acting partner, who takes part in the management of the business; (2) sleeping partner, who has capital in the business but does not engage in its management; (3) limited partner, who has had his liability restricted to the amount of capital invested or to a known fixed sum - this is in accordance with the limited Partnership Act 1907 but it should be noted that there must be at least one unlimited partner; (4) quasi-partner, who has retired from active participation but has left his capital in the firm as a loan, the interest on which varies with the profits, and who allows himself to be held out as a partner (but is not in fact) thus incurring partnership liabilities.

The Partnership 125

The Partnership Agreement

Every partnership should be governed by an agreement which will cover the following:

(1) Capital. The amount each should contribute (which r.eed not be equal) and if it is to be a fixed amount.

(2) Division of profits. The manner in which profits and losses are to be divided.

(3) Interest. Whether capital should earn interest, the rate and method of calculation.

(4) Cu"ent accounts. Whether these should be maintained, carry interest, the rate and method of calculation and the maximum amount which may be drawn by each partner.

(5) Commission and salaries. Whether any partner is to be allowed a commission or salary before the division of profits and stating the amount or method of calculation of such commission or salary.

(6) Accounts. That audited sets of accounts be prepared and are binding on all partners.

(7) Goodwill. The method of valuation, when it should be valued and whether it is to appear in the books of account.

(8) Alteration. The notice required to be given by a retiring-partner, the manner in which his capital is to be repaid. How such capital is calculated.

(9) Death. On the death of a partner the method of calculation of his interest in the profits, the method of repayment and interest rate on the unpaid balance.

The Partnership Act 1890

Where there is no partnership agreement or where such an agreement is silent the Partnership Act 1890 will apply. The main accounting provisions of the Act are as follows:

(1) All partners are entitled to share equally in the capital and profits and contribute equally towards losses.

(2) Where a partner makes a loan or advance beyond the required capital he will be entitled to interest on such an amount at 5% per annum.

(3) A partner is not entitled to interest on capital. ( 4) No partner is entitled to remuneration for acting in the business. (5) On the death of a partner his estate is entitled to interest at 5% or some

other appropriate rate, on the balance due, from the date of death to the date of payment.

Some other important provisions of the Act are: (1) The partnership books are to be kept at the business premises or principal

office and every partner must have access to them. (2) Partners must not work for competing businesses without the consent of

the other partners. Any profits so made must be brought into the partnership. (3) Every partner is entitled to take part in the management of the business.

Ow

ners

hip

Ris

k to

ow

ners

' pe

rson

al a

sset

s

Man

agem

ent

of

firm

Info

rmat

ion

publ

icly

av

aila

ble

Tabl

e 6.

1 M

ain

Dif

fere

nces

Bet

wee

n a

Sole

Tra

der,

a

Par

tner

ship

and

Lim

ited

Com

pani

es

Sole

Tra

der

One

ow

ner

Unl

imit

ed

Dec

ided

by

sole

tr

ader

Non

e: b

usin

ess

nam

e ha

s to

be

regi

ster

ed

if it

is n

ot o

wne

r's

nam

e

Par

tner

ship

L

imit

ed C

ompa

ny

Nor

mal

ly n

o m

ore

than

D

ivid

ed i

nto

shar

es (

two

or m

ore,

eve

n fo

r tw

enty

. R

ight

s an

d du

ties

set

publ

ic c

ompa

nies

). R

ight

s o

f sha

reho

lder

s ou

t in

an

agre

emen

t -

in e

ach

clas

s o

f sha

reho

ldin

g de

fine

d in

pa

rtne

r's r

ight

s an

d du

ties

co

mpa

ny's

mem

oran

dum

and

art

icle

s. E

ach

may

not

be

iden

tica

l. C

hang

e sh

are

of a

cla

ss r

anks

equ

ally

. Gre

at s

ub-

of o

wne

rshi

p m

ust

be

divi

sion

of

owne

rshi

p po

ssib

le.

Dis

posa

l ag

reed

by

all

of s

hare

s m

ay n

ot r

equi

re c

onse

nt o

f com

Unl

imite

d. A

ny f

ull

part

ner

is re

spon

sibl

e fo

r all

the

fir

m's

deb

ts

By a

gree

men

t be

twee

n th

e pa

rtne

rs

Non

e: p

artn

ersh

ip n

ame

has

to b

e re

gist

ered

if i

t is

not

part

ners

' nam

es

pany

. L

imit

ed t

o th

e am

ount

per

sha

re n

orm

ally

pa

id w

hen

shar

es f

irst

iss

ued

By

boar

d o

f dir

ecto

rs w

ho a

re e

lect

ed b

y th

e sh

areh

olde

rs a

nnua

lly

File

mai

ntai

ned

at C

ompa

nies

Hou

se w

hich

co

ntai

ns le

gal

docu

men

ts o

f fo

rmat

ion.

A

nnua

l re

turn

sho

win

g di

rect

ors,

acc

ount

s,

regi

ster

of m

embe

rs o

pen

for

insp

ecti

on.

Aud

it r

equi

red

by i

ndep

ende

nt a

ccou

ntan

t.

Dep

t. o

f Tra

de a

nd I

ndus

try

has

supe

rvis

ion

of a

ll co

mpa

nies

W

ithdr

awal

of

prof

its

As

owne

r de

cide

s A

s pa

rtne

rs d

ecid

e B

y di

vide

nd t

o sh

areh

olde

rs -

may

be

a fi

xed

amou

nt o

r va

ry d

epen

ding

on

clas

s o

f sha

re.

Dec

ided

by

dire

ctor

s

......

N

0\

~

~

:::: ;::s IS- ... cs· ;::s s· ~ s· ~ ~

<") 8 :::: ;::s ... ~-

Sole

Tra

der

Par

tner

ship

Wit

hdra

wal

of

capi

tal

As

owne

r de

cide

s A

s pa

rtne

rs d

ecid

e

Acq

uisi

tion

of

new

D

epen

dent

on

owne

r's

Dep

ende

nt o

n pa

rtne

rs'

fund

s ot

her

than

pe

rson

al a

sset

s or

pe

rson

al a

sset

s or

intr

o-

from

pro

fits

hi

s ab

ilit

y to

bor

row

, du

ctio

n o

f add

itio

nal

ther

efor

e li

mit

ed

part

ners

. The

refo

re

expa

nsio

n ex

pans

ion,

tho

ugh

grea

ter

than

sol

e tr

ader

, stil

l ha

s an

abs

olut

e li

mit

. N

ew p

artn

ers

mea

n ch

ange

s in

pro

fit

dist

ribu

tion

Art

icle

s o

f N

one

Agr

eem

ent,

verb

al o

r

Gov

ernm

ent

wri

tten

Law

(m

ajor

are

as)

Cas

e, S

tatu

te a

nd

Par

tner

ship

Act

189

0;

Com

mon

Law

L

imit

ed P

artn

ersh

ip A

ct

1907

; Cas

e, S

tatu

te a

nd

Com

mon

Law

Lim

ited

Com

pany

Rep

aym

ent

of

capi

tal

stri

ctly

con

trol

led

by

lega

l pr

oced

ure

Issu

e o

f fu

rthe

r sh

ares

or

debe

ntur

es b

ut

may

cha

nge

'pow

er' b

alan

ce i

n fi

rm.

Issu

e o

f de

bent

ures

sec

ured

on

the

asse

ts, l

imit

ed

by t

he a

mou

nt o

f sec

urit

y av

aila

ble.

As

inve

stor

s' r

isk

is li

mit

ed t

he t

otal

con

tri

buti

on is

lik

ely

to b

e gr

eate

r th

an f

or s

ole

trad

ers

and

part

ners

hips

so

that

exp

ansi

on

is un

lim

ited

Mem

oran

dum

and

Art

icle

s o

f A

ssoc

iatio

n

Com

pani

es A

cts

1948

and

196

7; C

ase

and

Sta

tute

Law

~

~ ~

:::t ;:s ~ ~ -6" .......

t-..) 'l


(4) The partnership must indemnify every partner for payments or liabilities incurred, in the ordinary course of business, for the preservation of the firm's property or business.

Partnership Accounts

There is no difference in the book-keeping for a partnership. The year-end adjustments and the final accounts are prepared in exactly the same way as a sole trader, except for the treatment of the proprietor's interest and the changes to it.

It is usual to have two accounts for each partner, one which records his capital investment in the business and the other which is his current account, through which all transactions affecting the partner will pass. Capital accounts do not normally change.

The current account is credited with the share of the profits, interest received and other specific income. It is debited or charged with cash withdrawn, interest and the cost of stock withdrawn.

Prior to the division of profits it is often agreed to compensate the partners for loss of income which could have been earned by investing their funds elsewhere. Where a partner has provided a substantial amount of capital but takes little part in the management and is only entitled to a small share of the profits this interest acts as compensation. These divisible profits are reduced by the interest charge.

Similarly where a partner devotes considerable time or expertise but little capital he would be compensated by way of salary, this also appearing as a charge prior to profit sharing.

Entries in the accounts would be:

On formation:

Profits earned:

Drawings:

Interest received on Capital:

Interest payable on overdrawn accounts

Dr. Various Asset Accounts } C I d .. d 1 C "tal A t Assets Introduced r. n 1v1 ua ap1 ccoun s

Dr. Profit and Loss Account l p , h f th artners s are o e

Cr. Individual Current Account · profits

Dr. Individual Current Account} Am . hd C C h ounts w1t rawn r. as

Dr. Profit and Loss Account

Cr. Current Account

Dr. Current Account

Cr. Profit and Loss Account

l Amount of interest based on the capital

l Amount charged on overdrawn account

It is easier to use a columnar form when writing up the partners' accounts as this aids accuracy and speed.

The Partnership 129

A, B and C decided to form a partnership and share profits and losses in the ratio 3 : 2 : 1.

A introduces the following assets: buildings at valuation £6,000 motor vehicles 300

B introduces the following assets: debtors 2,000 cash 1,500

C introduces the following assets: stock 2,300 cash 1,200

Capital Account

A B c A B c Buildings 6,000 Car 300 Debtors 2,000 Cash 1,500 1,200

Bal. c/d 6,300 3,500 3,500 Stock 2,300

£6,300 3,500 3,500 £6,300 3,500 3,500

Balances £6,300 3,500 3,500

Buildings

Capital Account 6,000 1

Motor VehiCles

Capital Account 300

Debtors

Capital Account 2,000

Cash

Capital Account (Band C) 2,700 I Stock

Capital Account 2,300

They decided to have fixed capital accounts, A £5,000; B £3,600; C £3,000; any excess of deficiency should be transferred to the current accounts:


Capital Accounts

A B c A Transfer to Balance b/d 6,300 Current a/c I ,300 500 Transfer to

Balance b/d 5,000 3,600 3,000 Current a/c

£6,300 3,600 3,500 £6,300

Balance b/d 5,000

Current Accounts A B c A

Capital a/c 100 Capital a/c 1 ,300

At the end of the first year:

A B Balance b/d 100 Drawings 5,000 2,500 Balance c/d 2,300 I,400

£7,300 4,000

Profit Drawings

£12,000 A £5,000 B £2,500 c £2,000

Current Accounts

c Balance b/d

2,000 Profit 500

2,500

A I ,300 6,000

£7,300

Balance b/d 2,300

The second year they decided: Direct charge to A £6,000 for purchases Special commission to C £500 Drawings A £6,050; B £2,000; C £2,000

B c 3,500 3,500

IOO

3,600 3,500

3,600 3,000

B c

500

B c 500

4,000 2,000

4,000 2,500

I ,400 500

Capital was to earn 5% interest; profit before interest adjustments, £15,580.

The Partnership 1 31

Current Accounts

A B c A B c Drawings 6,050 2,000 2,000 Balances 2,300 1,400 500 Purchases 6,000 Commission 500

*Interest (580) 250 180 ISO Balance c/d 4,580 1,650 Profit 7,500 5,000 2,500

(I 5,580 - 580) Balance c/d 2,000

£12,050 6,580 3,650 £12,050 6,580 3,650

Balance b/d 2,000 Balance b/d 4,580 1,650

* A 5% of 5,000 = 250 B 5% of 3,600 = 180 C 5% of 3,000 = 150

-580

In the third year they agreed that: (1) overdrawn current accounts would carry 10% interest; (2) B worked in the business full time and was to have a salary of £2,000 p.a.; (3) the profit before adjustments was £11,400:

Current Accounts

A B c A B c Balance b/d 2,000 Balance b/d 4,580 1,650 *Interest 200 Salary 2,000 Balance c/d 2,600 9,780 3,250 Profit for 4,800 3,200 1,600

tYear

£4,800 9,780 3,250 £4,800 9,780 3,250

Balance b/d 2,600 9,780 3,250

*10% of 2,000 = £200 on overdrawn account.

t Profit calculated: Profit and Loss Account

Salary to B Balance: A ~4,800 B ~ 3,200 c ~ 1,600

2,000

9,600

£11,600

Bal. 11,400 Interest Charged to A 200

£11,600


Note that the interest charged to A is shared between all the partners so that A only suffers £100 charge (£200 charge less 3/6 of200 = 100). To give full effect to the charge on A it could have been agreed that B and C share the charge in their profit-sharing ratio

B = 2 133 C= 1 67

200

No adjustment in the profit calculation is necessary.

Changes in the Partnership

It becomes necessary to review the value of the partnership when the asset value of the firm has changed and it has not been reflected in the accounts. For example, freehold land may have increased in value and plant become obsolete.

Revaluation of assets is particularly important before a new partner is brought into the business, so that the old partners receive full credit for the changes which occurred while they managed the firm. The revaluation in its simplest form requires only the adjustments of the original partners' current accounts with their share of the profit or loss on revaluation.

The sequence of events is as follows: (1) calculate through a Revaluation Account the profit or loss on the change in value of the net assets; (2) adjust the partners' current accounts for their share of the profits or losses; (3) where a new partner is being introduced, create his capital and current accounts and increase the asset accounts by the assets introduced; (4) make any necessary adjustment between the capital and current accounts; (5) where an asset is not to appear at its revalued figure in the accounts write off the necessary amount against the partners' current accounts in the new profit-sharing ratio.

Although an asset may, at the date of revaluation, have a higher value than its book value the partners may wish to adopt the concept of prudence and not anticipate profits until they are realised. By writing the capital profit off in the new profit-sharing ratio this will automatically ensure that when the asset is realised the partners receive the benefit in accordance with the profit-sharing ratio, taking into consideration the period of time the various partners have been involved in the firm.

X and Y had been in partnership and then admitted Z: X andY had freehold property valued in the books at £8,000 When Zjoined (one yearlater) £12,000 When sold (two years later) £22,000

Cu"ent Account Method X Y Z

Profit on Revaluation £4,000 2,000 Written off (1,333)

Balance 667 Profit on Sale 4,667 22,000-8,000 = 14,000

Final Profits

Goodwill

£5,334

2,000 (1,334 (1,333)

666 (1,333)

4,667 4,666

5,333 3,333

The Partnership 133

Apportionment Profit on Sale £14,000

X y Yr. 1 4,000 2,000 2,000 Yr. 2 10,000 3,334 3,333

14,000 5,334 5,333

z

3,333 3,333

Notice how the profit is apportioned on a time basis and divided between the partners at that time in the profit-sharing ratio.

It has been argued that goodwill is the difference between the value of the assets of the business and the amount of money which a purchaser would pay for the business as a going concern. There are various ways of calculating goodwill and the particular method selected will depend on the wishes of the partners.

It has also been argued that goodwill cannot exist and is only caused by the lack of accurate valuations of the assets forming part of a going concern.

The main problem with these arguments is in defining 'value'. As has been asked before, value to whom, for what and when?

It is intended here to treat goodwill as an asset which may or may not appear in the accounts, depending on the wishes of the partners.

L and M had been in business successfully for a number of years, sharing profits and losses equally, and have decided to introduce a new partner, P. The summarised partnership Balance Sheet was as follows:

Fixed Assets Freehold Premises Plant and Machinery Motor Vehicles

Net Current Assets

Capital Accounts L M

Current Accounts L M

Balance Sheet

5,000 5,000

3,000 1,000

6,000 4,500 2,500

13,000 1,000

£14,000

10,000

4,000

£14,000


Prior to the introduction of P the firm was revalued: Freehold Premises 20,000 Plant and Machinery 2,000 Motor Vehicles 2,500 Goodwill 6,000 Net Current Assets 1 ,500

(The goodwill was calculated as being equal to double the average annual profits for the last six years.)

Freehold Premises Balance 6,000 Revaluation Balance c/d 20,000

Profit 14,000

£20,000 £20,000

Balance b/d 20,000

Plant and Machinery

Balance 4,500 Revaluation

£4,500

Balance b/d 2,000

Loss Balance

2,500 2,000

£4,500

Various Net Current Assets Balance 1,000 Revaluation Balance c/d I ,500

Profit 500

£1,500 £1,500

Balance b/d 1,500 I Capital Accounts

L M Bal. 5,000 5,000

Revaluation Plant and 2,500 Freehold 14,000

Machinery Net Current Assets 500

Transfer Goodwill 6,000

Current a/c L50% 9,000

M 50% 9,000

£20,500 £20,500

Goodwill Revaluation 6,000

Motor Vehicles Balance

2,500 I

Current Accounts

L M Bal. 3,000 1,000 Profit on Re-valuation

9,000 9,000

12,000 10,000

The Partnership 135

P was to introduce a motor car valued at £2,000 and cash £4,000. It was also agreed that they would have fixed capital accounts of £3,000 each and share profits equally.

Motor Vehicles Net Current Assets Balance 2,500 Bal. c/d 4,500 Balance 1,500 Balance c/d 5,%J Introduced Introduced by p 2,000 by p 4,000

£4,500 £4,500 £5,500 £5,500

Bal. b/d 4,500 Balance b/d 5,500

Current Accounts L M p

Balance 12,000 10,000 Capital 2,000 2,000 3,000

Capital Accounts

L M p L M p Current a/c 2,000 2,000 3,000 Balance 5,000 5,000 Balance 3,000 3,000 3,000 Motor 2,000

Vehicle Cash 4,000

£5,000 5,000 6,000 £5,000 5,000 6,000

Bal. b/d 3,000 3,000 3,000

It was also decided that the goodwill should not appear in the Balance Sheet.

L M Goodwill 2,000 2,000 Balance c/d 12,000 10,000

£14,000 12,000

Revaluation

Current Accounts p

2,000 Balance 1,000 Capital a/c

3,000

Bal. b/d

Goodwill

6,000

£6,000

L M p

L 12,000 2,000

£14,000

12,000

M 10,000 2,000

12,000

10,000

2,000 2,000

p

3,000

3,000

1,000

2,000 6,000

£6,000


The Balance Sheet, after the introduction ofP, was as follows:

Fixed Assets Freehold Premises Plant and Machinery Motor Vehicles

Net Current Assets

Capital Accounts L M p

Current Accounts L M p

Balance Sheet

3,000 3,000 3,000

12,000 10,000

1,000

20,000 2,000 4,500 5,500

£32,000

9,000

23,000

£32,000

Many other changes to a partnership are possible, such as the change of profitsharing ratios after a revaluation, the assets remaining at the old values. The same principle should be used: (1) calculate the profit/loss on revaluation; (2) credit the partners with the revaluation profit in the original ratio; (3) reverse the credit by writing it out in the new ratio.

Dissolution of a Partnership

Eventually a partnership may have to be dissolved as a result perhaps of disagreement, poor trade, retirement or death and the assets will have to be sold off, cash collected and the remaining capital returned to the partners.

A Realisation Account will be used to calculate the profit or loss on winding up the firm, by comparing the cost of the assets with the revenue obtained on their disposal. It is comparable with a Profit and Loss Account. The difference is the profit or loss which is transferred to the partners in the profit-sharing ratio.

Balance Sheet

Fixed Assets Plant and Machinery Motor Vehicles

Current Assets Stock 5,000 Debtors 4,000 Bank 6,000

15,000 Less Creditors 3,500

Capital Account E 10,000 F 5,000

Current Account E 6,500 F 5,000

The assets were disposed of as follows: Sold: Plant and Machinery

Stock

12,000 3,000

15,000

11,500

£26,500

15,000

11,500

£26,500

Transferred: Motor Vehicles, to E

Realised: Debtors Paid: Creditors

Plant and Machinery Bal. 12,000 Reali-

sation a/c 12,000

F

Bal.

The Partnership 137

Motor Vehicles 3,000 Realis

ation a/c

7,000 8,000

500 500

3,600 3,800

3,000


E Loss on Realisation 2,350 Bank 13,650

£16,000

E Realisation: Cars 500

Capital a/c 6,000

£6,500

Stock

Balance 5,000

--

Plant and Machinery Motors Stock Debtors Additional Creditors

Reali-sation

a/c

Creditors

Capital Accounts

F E 2,350 Balance b/d 10,000 7,150 Current a/c 6,000

£9,500 £16,000

Current Accounts

l' E

500 Balance b/d

--------~

6,500 4,500

£5,000

5,000 --

Realisation

12,000 3,000 5,000 4,000

300

£24,300

£6,500

Debtors

Bal. 4,000

Bank re Plant Stock Debtors

Tfs. E. Car F Car

Realis-ation

a/c

Capital a/c Loss E 2,350 F 2,350

Bank Cash £3,800 Balance 3,500 Balance

Debtors 6,000 3,600

Creditors E Realisa-

tion a/c 300 F

Plant 7,000 Stock 8,000

£3,800 £3,800 £24,600

F 5,000 4,500

£9,500

I'

5,000

£5,000

4,000

7,000 8,000 3,600

500 500

4,700

£24,300

3.800 13,650

7,150

£24,600

Note: The last transaction is always the cash settlement of the Capital Accounts because immediately prior to that the Balance Sheet appears:

Assets: Cash £20,800

Capital a/c E F

13,650 7,150

£20,800

The Partnership 139

All losses or profits have been shared between the partners. The assets may be transferred directly to the partners, which is normal where one of the partners intends to carry on the business.

One problem which arises on the dissolution of a partnership is the delay which may occur between the disposal of individual assets and the ascertaining of the overall profit or loss. The partners will require payment of available cash. If care is not taken overpayment to one partner could arise, as the extent of any losses will not be known until all cash has been received. One method which can be used when the partners are to be paid periodically is that the remaining assets not yet realised or transferred should be treated as a loss and written off against the partners' accounts. This will leave their accounts equal to the cash and will show the amount each partner is to receive.

Immediately after the distribution the assumed loss is cancelled pending further receipts of cash. This operation is repeated every time the partners receive a payment.

Balance Sheet

Net Assets £14,000 I st Cash receipt £6,000 2nd cash receipt £5,000 Final receipt £7,000

Partners: a/c R 9,000 s 5,000

£14,000 £18,000 Partners' Accounts R s Balances 9,000 5,000 Less assumed loss 4,000 4,000 (14,000- 6,000 = 8,000, split equally as no agreement)

5,000 1,000 Less cash paid (6,000) (5,000) (I ,000)

Original Capital b/f 9,000 5,000 1st payment 5,000 1,000

Balance 4,000 4,000 Less assumed loss {8 ,000 - 5,000 = 3,000) 1,500 1,500

2,500 2,500 Less cash paid (5,000) (2,500) (2,500)

Original Capital b/f 9,000 5,000 1st and 2nd payment 7,500 3,500

Balance 1,500 1,500 Profit on final settlement 2,000 2,000 (3,000 -7,000 = 4,000

or 18,000- 14,000 = 4,000)

Final Settlement £3,500 £3,500


Summary Balances Profit (18,000- 14,000)

Cash paid: 1st 5,000 2nd 2,500 3rd 3,500

R 9,000 2,000

11,000

11,000

1,000 2,500 3,500

s 5,000 2,000

7,000

7,000

Where a partner has a debit balance on his account on realisation and does not have personal assets which he could use to pay the debt (the partner is bankrupt) the other partners will have to bear that partner's debt in their profitsharing ratio or, where there is no agreement, in the ratio of their last agreed capital balances (Garner v. Murray).

Questions

6.1 H and R were partners, sharing profits and losses in the proportions H twothirds and R one-third. Their balance sheet at 31 October was as follows:

Capital Accounts

H R

Creditors

20,000 8,000

Balance Sheet

28,000 5,400

£33,400


12,800 20,600

£33,400

R has proposed that, as from 1 November, X Ltd should take over all the assets and liabilities of the partnership and that the purchase price should be £40,000, to be satisfied by the issue of 32,000 ordinary shares in X. Ltd, at a valuation of £1.25 each.

The issued share capital of X. Ltd, before putting the above proposal into effect, was 36,000 ordinary shares of £1 each, 32,000 of which were held by R.

You are to assume that the assets of the partnership are shown in the above Balance Sheet at fair valuations and that a fair valuation of the goodwill of the partnership business is £5,000.

You are also to assume that the whole business of X. Ltd, at the date of the proposal, is fairly valued at £45,000.

You are required to show the closing entries that would be made in the partnership books if the foregoing proposals were put into effect, and to give your views on the proposals, assuming that H asked your advice.

The Partnership 141

6.2 Richmond, Merton and Tolworth carried on a retail business in partnership. The partnership agreement provided that:

(1) The partners are to be credited at the end of each year with salaries of £1 ,000 to Richmond and £500 each to Merton and Tolworth and with interest at the rate of 5% per annum on the balances at the credit of their respective capital accounts at the beginning of the year.

(2) No interest is to be charged on Drawings. {3) After charging partnership salaries and interest on capital, profits and

losses are to be divided in the p-roportion: Richmond SO%, Merton 30% and Tolworth 20%.

The Trial Balance of the firm at 31 December was:

Partners' Capital Accounts: Richmond- Balance 1 Jan. Merton- Balance 1 Jan. Tolworth- Balance 1 Jan. Partners' Current Accounts Richmond - Balance 1 Jan. Merton - Balance 1 Jan. Tolworth - Balance 1 Jan. Sales Trade Creditors Shop Fittings at cost Shop Fittings Provision for depreciation 1 Jan. Freehold Premises - cost Leasehold premises - purchased during the year Leasehold premises - additions and alterations Purchases Stock on hand, 1 January Salaries and Wages Office and Trade Expenses Rent, Rates and Insurance Professional Charges Debtors Provision for doubtful Debts, 1 Jan. Balance at Bank Drawings, other than monthly payments Richmond Merton Tolworth

DR.

3,600

6,000 4,500 2,500

28,000 4,200 6,400 4,520 1,050

350 2,060

4,370

1,700 1,100

900

£71,250

CR.

8,000 5,000 3,000

1,600 1,200

800 46,500

3,700

1,400

so

£71,250


You are given the following additional information: (I) Stock on 31 December was valued at £3,600. (2) A debt of £60 is to be written off and the provision against the remaining

debtors should be 5%. (3) Salaries and Wages include the following: monthly drawings by the

partners: Richmond £50, Merton £30, Tolworth £25. (4) Partners had during the year been supplied with goods from stock and it

was agreed that these should be charged to them as follows: Richmond £60, Merton £40.

(5) On 31 December rates paid in advance and office and trade expenses owing were £250 and £240, respectively.

(6) Depreciation of shop fittings is to be provided at 5% per annum on cost. (7) Professional charges include £250 fees paid in respect of the acquisition

of the leasehold premises, which fees are to be capitalised. (8) The cost of and the additions and alterations to the leasehold premises

were to be written off over 25 years, commencing on 1 January in the year in which the premises were acquired.

You are required to prepare: (a) the trading and Profit and Loss Account for the year ended 31 December; (b) the Balance Sheet as on that date; (c) partners' Current Accounts in columnar form for the year ended 31 December.

6.3 X, Y and Z were partners, sharing profits and losses in the proportions X one-half, Y one-third, Z one-sixth. The Balance Sheet of the firm as on 31 March was:

Capital accounts: X y z Creditors

8,320 5,160 1,930

Balance Sheet

15,410 11,390

.£26,800

Fixed assets Current assets:

Stock in trade Debtors

Balance at bank

9,370 6,845 3,085

7,500

19,300

£26,800

On 1 April the goodwill, fixed assets and stock in trade were sold to AB. Ltd for £20,000. On the same day, the purchase consideration was satisfied as to £14,000 in cash, and as to the balance by the issue of 4,500 shares in AB Ltd. valued at £1.33 each.

The firm's debtors included £30 due from M and £120 due from N. Both of these debts had been guaranteed personally by Y.

By 10 April, £2,970 had been collected from the firm's debtors. On that day, the creditors were paid subject to discounts amounting to £175. The shares in AB. Ltd were divided in the proportions X one-half, Y one-third and Z onesixth, and all the available cash was paid out to the partners in such proportions as to exclude the possibility of an overpayment being made to any partner.

Between 11 April and 30 April a further £3,600 was collected from the firm's debtors, including £30 from M. The remaining debts, including N's debt of £120 were regarded as bad.

The Partnership 143

The final distribution of cash was made on 30 April. You are required: (1) to prepare the realisation account, the cash account and

the capital accounts of the partners, distinguishing between the interim and final distributions of cash; and (2) to show your calculation of the interim distribution of cash on 10 April.

6.4 Two partners, A and B, draw salaries of £4,500 and £4,000, respectively, and share profits 5:3. Their capital accounts were A £15,000, B £9,000.

On I July they agree to admit C and D on the following terms: C to introduce £9,000 as Capital in the form of Plant and Equipment; D to bring in £4,000 as cash, and it was agreed that for the next three years £1 ,200 would be deducted from his salary and transferred to his capital account.

The partnership assets were revalued and the resulting capital profit, £12,000, transferred to A and B, in their profit-sharing ratios.

The new agreement included the following: Salaries: A £5,000, B £4,500, C £3,000, D £3,000. Interest on Capital: 8% on balances at end of year (no apportionment for

part-years). Profit-sharing ratios: A 8/18, B5/18, C 3/18,02/18 The profit for the year to 31 Dec, after charging salaries on the old basis and

before taking into account the above adjustments, was £25,516. You are required to show the entries in the Profit and Loss Account and the

capital and current accounts of the partners.

CHAPTER 7

long-Term Finance: Share Capital and Debentures

Different types of trading organisation obtain their funds as follows:

(1) The sole trader. Private funds and loans from banks and friends. No legal requirements to be observed.

{2) Partnerships. Each partner contributes an amount from his private funds according to the partnership deed. Additional funds from banks or interested parties. Few legal restrictions.

{3) Limited companies. Funds obtained by approaching general public. Private companies restricted by Companies Act 1948 as to number they can approach. Public companies have no restriction on number contributing capital. Amount contributed only restricted by, the terms of Memorandum of Association. Urnited companies can approach banks and general public for loans. Individuals become members by applying for and being allotted shares in a company. The method of advertising and allotting is set out in the Companies Act 1948.

The Companies Act 1948

Section 26 (i) Persons who subscribe to memorandum are deemed to be members of the

company. (ii) Persons who agree to become members and whose names are entered in

the share register shall be a member of the company. Section 38

Prospectus must contain inter alia the following matters: Minimum amount required to pay for

(a) purchase price of any property; (b) preliminary expenses and commissions; (c) repayment ofloans raised for either (a) or (b); (d) working capital.

The amount payable on application and allotment of shares. The rights as to voting and dividends of the various classes of shares where the

company has more than one class of share. The amount of preliminary expenses/issue expenses and underwriting

commission or rate of commission.

Long-Term Finance: Share Capital and Debentures 145

An auditors' report showing profits and losses for five years and assets and liabilities at last accounting date. Section 47

Shares not to be allotted unless minimum subscription obtained. Amount payable on application must be at least 5% of nominal value of share. Application monies must be received within 40 days of issue of prospectus. In event of monies being returned this must be carried out within a further eight days.

Section 50 Prospectus must be in issue at least three days before any shares allotted.

Section 51 Where company is applying for permission to the Stock Exchange for the

shares to be traded on the Exchange, application monies must be maintained in a separate bank account.

Section 53 Company may pay underwriting commission; must not exceed 10% of issue

price of shares.

Section 56 If shares issued at a premium the premium must be placed in a Share

Premium Account. This account may be used to write off: (a) preliminary expenses; (b) commissions; (c) discounts on issues; (d) the premium arising when redeeming preference shares.

Section 57 Company may only issue shares at a discount if, (a) company has been in business at least one year; and (b) company in general meeting has passed resolution agreeing to issue and

the court has sanctioned scheme. Section 66

A company may, if authorised by its Articles and if members so resolve, reduce its capital by cancelling any part of the shares previously paid for in order to extinguish the value of lost assets. Scheme requires court sanction. Section 92

A contract to take up and pay for debentures can be enforced by an order for specific performance (there is no such provision in respect of share issues).

N.B. (i) Companies must retain receipts in a separate account pending successful conclusion of fund-raising operation.

(ii) No minimum amount is stated as nominal value of a share; this is at the discretion of the company when formed.

(iii) The account in which cash is placed, termed the Application and Allotment Account, is a form of sundry creditor. After allotment of the shares, the company treats the balance of money due, if any, as a sundry debtor.


Share Issues

A company offers shares of £1.00 each to the public, the full amount for each share being payable with the application.

Bank Account Application and Allotment Account

£1,000,000 ~c~ Received on I Application £1,000,000

After examination of application forms the board decides to allot the shares to applicants who become members of the company.

Application and Allotment Account

I m. shares of £1 allotted

Share Capital £1 m.

Bal. b/d £1m.

Share Capital Account

I m. Shares of £1 allotted £I m.

The members are creditors of the company, although they will never be repaid. Any member who wishes to withdraw will have to sell his share in the company (one or more shares) either through the company obtaining a buyer, if it is a private company, or via the stock market in the case of a public company.

A company will attempt to repay its capital when going out of business. In such circumstances the shareholders usually receive less than their original contribution because the company has lost its funds through adverse trading conditions.

Expenses Incurred in Company Formation and Share Issues

Formation or preliminary expenses include cost of registering the company, printing of Memorandum and Articles of Association, promoters' and solicitors' fees. Share issue expenses include cost of printing prospectus, advertising the issue, auditors' fees, underwriters' commission, etc.

Such expenses will be met from the proceeds of the share issue, thus reducing the funds available for purchase of fixed assets and provision of working capital.

The company in the previous example incurs formation expenses of £125,000 and issue expenses of £80,000.

Balance b/d

Balance b/d

Balance Sheet

Share Capital I m. shares of £I each

Bank Capital expenses

not written off: Formation Costs Issue Expenses


Bank

I ,000,000 Formation Cost Issue Expenses Balance c/d

£I ,000,000

795,000

I25,000 80,000

795,000

£I ,000,000

Shareholders only have 79'l2p per member represented by assets.

£I ,000,000 Balance has been used for expenses; these will be charged against future

795,000 profits.

Assets I25 ,000 Shares 80,000

£I ,000,000

£795,000 1,000,000

Shares Issued at a Premium

In order to prevent the capital of the company being used to meet the costs of formation and issue, the price at which the shares are offered will take into account both the capital required to finance the business and the expenses of the issue. This difference between the nominal value and issue price of the share is known as the 'Share Premium' and is a capital profit. It can be used to write off capital expenses as set out in Section 56.

Shares will also be issued at a premium if the promoter considers the company will attract considerable applicants and the market price is likely to commence above the nominal value. In the case of an existing company where the market value is already higher than the nominal value, the issue price will be commensurate with market price to eliminate excessive dealings.

If the company issues its I m. shares of £I at a price of £I.25 and incurs expenses of £205,000 the entries would be as follows:

Application Monies 1 m. shares@ £1.25

Balance

Bank

1,250,000 Formation Expenses Issue Expenses Balance

£1,250,000

1,045,000

125,000 80,000

1,045,000

£1,250,000


Application and Allotment Account

Shares Allotted 1 m. @ £1.00 each Share Premium 1m. @£0.25

Transfer from Formation Expenses

Issue Expenses Balance

Bank

Bank

Balance Sheet

Bank

Share Capital 1 m. shares of £1 Share Premium

1 ,000,000 Bank 1,250,000

250,000

£1,250,000 £1,250,000

Share Capital

I Shares Allotted 1,000,000

Share Premium

125,000 80,000 45,000

£250,000

Application and Allotment a/c

Balance

250,000

£250,000

45,000

Formation Expenses

£125,000 Transfer to Share Premium £125,000

Issue Expenses

£80,000

£1,045,000

1000,000

45,000

£1,045,000

Transfer to Share Premium £80,000

Members' capital is intact. There is a capital profit available to meet any further capital expenses. The shares are worth £1.04~:

Assets £1_,045_,000 Shares 1 ,000,000


Underwriting of a Share Issue

In order to ensure that all the shares are applied tor and thus to avoid the necessity of refunding monies after an unsuccessful issue, with consequent inability to commence trading or insufficient funds to carry out intended expansion, a company takes out an insurance against possible short-fall in applications. This insurance is known as 'Underwriting' and involves a_!ranging with a finance house to pay for any shares not applied for by the public. The underwriter will charge a commission, the insurance premium, for his services.

The commission, when charged to the company, is written off against share premium or revenue profits.

The 1m. shares of £1.00 issued at £1.25 were underwritten at 3%. Formation and issue expenses were £205,000.

1 m. applications at £1.25

Balance b/d

Shares Allotted Share Premium

Formation Expenses Issue Expenses Underwriting

Balance

Bank

1,250,000 Formation Expenses

£1,250,000

1,007,500

Issue Expenses Underwriting Commission

3% of £1,250,000

Balance c/d

Application Account

1 ,000,000 Bank 250,000

£1,250,000

Share Premium

125,000 80,000 37,500

242,500 7,500

£250,000

125,000 80,000 37,500

242,500 1,007,500

£1,250,000

1,250,000

£1,250,000

250,000

£250,000

Balance 7 ,500

Capital Formation Expenses

1m. Bank 125,000 Transfer Shares to Share @ £1 1,000,000 Premium 125,000


Issue Expenses

Bank £80,000 Transfer to Share

Underwriting

Bank £37,500 Transfer to Share Premium 37,500

Premium 80,000

Balance Sheet

Bank

Share Capital 1 m. shares of £1 Share Premium

£1 ,007,500 Note that due to payment of underwriting commission, assets have been reduced -members' holding now

1,000,000 worth £1.0075 7,500 Assets £1.007,500

£-,-l,-,0-:-0=-7-,5-0~0 Shares £1,000,000

The underwriting commission is calculated on the total value of the share issue, this being the amount payable by the underwriter if there were no applications from the general public.

Where the underwriter is obliged to take up shares the commission will be deducted from the amount he is due to pay.

Using the original example of lm. shares of £1 issued at £1.25 and assuming that the public only subscribed for 600,000 shares, the underwriters would be obliged to purchase the remaining 400,000 shares. They would, however, charge their commission of £37,500.

600,000 applications @ £1.25

Underwriters

Balance

600,000 shares of £1.00

Share Premium@ £0.25

400,000 shares @ £1.25

Bank

750,000 Formation Expenses Issue Expenses

462,500 Balance

£1,212,500

1,007,500

Application Account

600,000 Bank

150,000

£750,000

Underwriters

500,000 Commission Bank

£500,000

125,000 80,000

1,007,500

£1,212,500

750,000

£750,000

37,500 462,500

£500,000

Long-Term Fi!Ulnce: Share Capital and Debentures 151

Formation Expenses Issue Expenses Underwriting Balance

Share Capital

Application Account Underwriters

Share Premium

125,000 80,000 37,500

7,500

£250,000

Application Account Underwriters

Balance

Balance Sheet

Bank

Share Capital Share Premium

£1,007,500

1,000,000 7,500

£1,007,500

600,000 400,000

£1,000,000

150,000 100,000

£250,000

7,500

The company's financial state is exactly as in the previous example, since the whole of the issue has been taken up. The underwriters will have a controlling interest as they are the majority shareholder.

The share capital account is a control account on the individual member's

account appearing in the share register. Periodically an audit will be carried out on the register to ensure that all transfers have been correctly recorded and that individuals have not sold more shares than originally held.

The entries for the following two share issues, both taking place on the same day, will be shown and the results compared.

Company A offered 10,750,000 shares of £0.20 each at a price of £0.70 each, payable in full on application in order to reduce short-term loans and to convert a private company to a public one. Minimum application was 200 shares.

Expenses would be £160,940 and the issue was underwritten at 1 Yl%. Appli

cations totalled 186 m. shares and were allotted on an approximately 5% basis of number applied for, with a maximum of 5,000 shares. Applicants for up to 500 were balloted and drawn in the proportion to total applications.

Company B offered 800,000 shares of £0.10 each at a price of £0.85, payable in full on application. Minimum application 200 shares. The issue would convert

a private company to a public one. Expenses would be £39,500 and the issue

was underwritten at 1 Yl%. Applications totalled 236,325 shares from 91 applicants, who were all allotted their shares in full. Underwriters were required to take up the remaining 563,675 shares.


Application Monies-186,000,000@ £D.70 each

Balance

10,750,000 shares Allotted@ £D.70 Refunds - Bank

Issue Expenses Underwriting Balance

Company A

Bank

130,200,000 Applications Refunded 175,250,000@ £D.70 Issue Expenses Underwriting 1%% on £7,525,000

£130,200,000 7,269,998

Balance

Application Account

7,525,000 Bank

122,675,000

£130,200,000

Share Capital

110,750,000 Slwes @£D.20

Share Premium

160,940 10,750,000 Shares 94,062 @ ro.so

5,119,998

£5,375,000

Balance

Share Issue Expenses

122,675,000

160,940

94,062 7,269,998

£130,200,000

130,200,000

£130,200,000

£2,150,000

5,375,000

£5,375,000

5,119,998

Bank £160,940 Transfer to Share Premium £160,940

Underwriting

Bank £94,062 Transfer to Share Premium £94,062

Balance Sheet

Bank £7,269,998

Share Capital 2,150,000 10,750,000 Shares@ £D.20 Share Premium 5,119,998

£7,269,998

Application Monies 236,325@ £0.85 Underwriters

Balance

Shares Allotted General Public 236,325 @ £0.85

Expenses Underwriting Balance c/d

Bank

Underwriters

Shares Allotted 563,675@ £0.85


CompanyB Bank

200,876 Expenses

470,624

£671,500

632,000

Balance

Application and Allotment

200,876 Bank

Share Capital

1800,000@ £0.10

Share Premium

39,500 8,500

552,000

£600,000

800,000@ £0.75

Balance b/d

Share Issue Expenses

39,500 632,000

£671,500

200,876

80,000

600,000

£600,000

552,000

39,500 Transfer to Share Premium 39,500

Underwriting

8,500 Transfer to Share Premium 8,500

Underwriters

479,124 Commission, 1%% of 680,000 Bank

£479,124

8,500 470,624

£479,124

Balance Sheet Note:

Bank Share Capital 800,000 Shares @ £0.10 Share Premium

£632,000 80,000

552,000 £632,000

Public Allotted Underwriter

Capital Premium

600,000

200,876 479,124

680,000

80,000 680,000


Comparison of the two issues

(1) Company A will have a large number of shareholders, no member having a controlling interest or more than 5,000 shares.

(2) Company B has few shareholders, the underwriters becoming the majority shareholder and controlling the company.

(3) The market price of shares in Company A will be above the issue price as unsuccessful applicants attempt to buy shares in the market.

(4) The shares of Company B, however, will fall below the issue price as the underwriters attempt to sell their holding. They may not reach the issue price, with resultant depressing effect on future share issues.

(5) Company A will require profits of £258,000 after tax to pay a dividend of 12% on the nominal capital. This requires a return on assets employed of 30.%:

£258,000

7,269,998 (6) Company B will only require profits of £9,600 for a dividend of 12% on

nominal capital, which will require a return of 10.% on the assets employed: £9,600

632,000

Debenture Issues

The procedure for the issue of debentures is the same as outlined for a share issue, with the exception that there is no legal restriction on the issue of a debenture at a price below its nominal value (i.e. issued at a discount). The discount is either written off to the Share Premium at the time of issue or to revenue reserves over the life of the debentures.

Where they have not been written off, any expenses on the issue of shares and debentures must be shown on the Balance Sheet.

A company issues a £200,000 10% debenture at a price of £96 for every £100 (i.e. at a discount of 4%), payable in full on application:

Bank 10% Debentures

Appcs. 2,000 @ £96 192,000

Debenture a/c

Discount on Debenture

8,000 Transfer to Share Premium or to Profit and Loss

Bank 192,000 Discount @4%on £200,000 8,000

£200,000

8,000

The company is obliged to pay 10% interest on £200,000 annually, even though they only received £192,000, and will eventually repay £200,000, together with any agreed premium.


Repayment of Capital and Loans

The rights of creditors of a company take precedence over those of shareholders. The Companies Act recognises this fact when restricting the repayment of capital, the conditions set out in Sections 66 (funds no longer required) and 58 (redeemable preference shares). Section 58

Issue of Redeemable Preference Shares must have been authorised by Articles: (a) Repayment only possible if shares are fully paid. (b) Proceeds may be obtained from new issue of shares or profits retained by

company. (c) If repayment takes place out of profits an amount equivalent to nominal

value of the redeemed shares must be transferred from revenue profits to a Capital Redemption Reserve Fund.

(d) The Capital Redemption Reserve Fund may only be used for the purpose of issuing bonus shares (fully paid).

(e) Where Preference Shares are redeemed at a premium this must be provided out of profits or share premium.

Whilst the Act refers to repayment out of profits this in fact means the use of the company's assets representing the retained profits of the company. Capital can only be repaid in cash and this is obtained either by issuing new shares or by disposing of assets and using the proceeds. In the latter case funds which would have been available for creditors are reduced and could be further reduced if dividends were declared out of available profits and then distributed in cash.

Ordinary Capital 100,000 Shares of £1 Redeemable Preference Capital, 50,000 Shares of £1

Profit and Loss

Fixed Assets Plant and Equipment

Current Assets Stock Debtors Investments Bank

Current Liabilities Creditors

Balance Sheet

4,000 1,000 5,000

100,000

110,000

30,000

100,000

50,000

150,000 50,000

£200,000

120,000

80,000

£200,000

156 A Foundation in Business Accountiag

Creditors are covered by bank balance. The remaining current assets are of little value. Company repays the Preference Shareholders, which reduces the bank to £50,000.

Bal.

Bank

100,000 Pref.

£100,000

Cap. Bal.

50,000

50,000

£100,000

Bank

Redeemable Pref Cap.

50,000 Bal. 50,000

The company now declares a dividend in view of the balance on the Profit and Loss Account. The payment eliminates the bank balance.


Div. so,oooiBal. 5o,ooo Bank

Bank

Bal. b/f 5o,ooolmv. Paid 50,000

Balance Sheet

Ordinary Capital 100,000 Shares of £1


Current Assets Stock Debtors Investments

Current liabilities Creditors

Net Current liabilities

4,000 1,000 5,000

10,000

30,000

Dividend Account

£100,000

120,000

20,000

£100,000

Even if creditors were able to dispose of the current assets at Balance Sheet values, funds would be insufficient to pay them. It is to avoid this possibility that the Companies Act requires the setting up of a Capital Redemption Reserve Fund (CRRF) when shares are redeemed out of the assets of the company. The Profit and Loss must therefore equal the nominal value of the shares being redeemed.

Having repaid the Preference Shares the Profit and Loss balance is transferred to Capital Reserve.



Trans. to Bal. £50,000 CRRF £50,000

Balance Sheet

Ordinary Capital 100,000 Shares of£1 Capital RRF


Current Assets Stock Debtors Investments Bank

Current Liabilities Creditors

4,000 1,000 5,000

50,000

60,000

30,000

100,000 50,000

£150,000

120,000

30,000

£150,000

Bal.

CRRF

ITrans. from P. and L. £50,000

Bank

100,000 Redptn. of Pre f. Shares 50,000

Creditors can be paid; the company will still have further funds available for other purposes. There is no possibility of declaring a dividend, as revenue reserves have been transferred to capital.

The CRRF, being a capital reserve, is part of the capital structure and total capital remains at £150,000 after redemption.

Redemption by New Share Issue

A company has in issue £100,000 of 7% £1 Redeemable Preference Shares and decides to repay them from the proceeds of a new issue of shares. These may be the same or a different class of shares.

Bal. (say) 2,000 New Share Issue 100,000 100,000 £1 Ord. Shares

£102,000

Balance b/d 2,000

Bank

Repayment of Redeemable Pref. Cap. Balance c/d

100,000 2,000

£102,000

Bank

7% Redeemable Pref Cap.

£ 100,000 Bal. £ 1 00 ,000

Ordinary Capital JBank £100,000 I


No change in total capital or cash resources. The company has dispensed with fixed dividend and will only declare a dividend in accordance with profits.

Redemption at a Premium

Where it is decided to repay the Preference Capital at a price higher than the nominal value, i.e. at a premium, the company is not required to make the new issue at a premium. The premium paid will reduce the company's cash and profits. Shares will be repaid at a premium in an attempt to compensate the holders for their fixed dividend during inflationary trends, or to attract new investment.

A company has 800,000 £1 6% Redeemable Preference Shares in issue to be redeemed at a premium of 2%. It will raise a new issue to provide nominal value.

Bal. (say) New Share Issue

Bank

20,000 Repaymt. of Redeemable

800,000 Pref. Cap 816,000 Balance 4,000

£820,000 £820,000

Balance 4 ,000

Profit and Loss Premium on Redemptn. ofPref. Shares 16,000 Balance 1 ,000

£17,000

Bal. (say) 17,000

£17,000

Balance 1 ,000

Share Capital

Bank 800,000

6% Redeemable Pref Cap.

Bank 816,000 Bal. 800,000

£816,000

Premium @2% (P. and L. a/c) 16,000

£816,000

No change in total capital. Assets and profits are reduced. If the company wishes to retain profits the new shares would be issued at a

premium. Apart from the profit consideration, the shares would be issued at a price which corresponded to the market value. The premium obtained can be used to offset the premium on redemption.

A company decides to issue 700,000 £1 shares at a premium of £0.30 in order to redeem 700,000 £1 6% Preference Shares at a premium of 2%.


Bal. (say) New Share Issue 700,000 Shares @£1.30

Bank

4,000 Paymt. to Pre f.

910,000 Sharehldrs 714,000 700,000£1 Shares@ 2% Balance 200,000

£914,000 £914,000

Balance 200,000

Share Premium

Premium 700,000 on @30p Redemptn. New ofPref. Issue 210,000 Shares 14,000 Balance 196,000

£210,000 £210,000

Balance 196,000

Bank

Share Capital

New Issue (Nominal Value) £700,000

6% Redeemable Pref Cap

714,000 Bal. 700,000 Premium @2% (Share Premium) 14,000

£714,000 £714,000

The company has improved its financial position. The Share Premium can be

used for capital expenses or bonus issue of shares. There is no change in total

capital. Due to the new issue no transfer to revenue profits to capital reserve is

necessary.

Redemption partially from new issues and existing resources.

Balance Sheet

Ordinary Share Capital 7% Redeemable Preference Share Cap. Profit and Loss


Stock Debtors Bank

Less Creditors

90,000 50,000

230,000

370,000 220,000

200,000 500,000 250,000

£950,000

800,000

150,000

£950,000


The company decides to make an issue of 400,000 £1 ordinary shares at a premium of £0.40 and to redeem the preference shares at a premium of 5%.

Note that capital raised, £400,000, is not equal to that being redeemed, £500,000. The balance, £100,000, must be transferred from the Profit and Loss Account to the Capital Redemption Reserve Fund.

Bal. New Issue 400,000 @£1.40

Balance

Trans. to CRRF Bal.

Bank

230,000 Redemptn. of Pref. Shares

560,000 500,000 @5% 525,000 Balance 265,000

£790,000 £790,000

265,000

Profit and Loss

100,000 150,000

£250,000

Bal. 250,000

Bal.

CRRF

Trans. from P and L.

£250,000

£150,000

100,000

Ordinary Capital

Bal. 200,000 New Issue 400,000

£600,000

Redeemable Preference Capital

Bank 525,000 Bal. 500,000 Premium 25 ,000

£525,000 £525,000

Share Premium

Premium 400,000 160,000 on Pref. @ £0.40 Share Redemptn. 25,000 Bal. 135,000

£160,000 £160,000

Bal. 135,000


Balance Sheet

Ordinary Capital Capital Redemption Reserve Fund

Share Premium Profit and Loss


Stock Debtors Bank

Less Creditors

90,000 50,000

265,000

405,000 220,000

600,000 100,000

700POO 135,000 150,000

£985,000

800,000

185,000

£985,000

Note the effect of the change in capital structure, although total capital remains the same. The prior charge of £35,000 preference dividend is eliminated. Total dividend requirements may have increased. Assuming that the company was paying an ordinary dividend of 12%, total profit required was:

7% Preference Dividend Ordinary Dividend (12% on 200,000)

Total dividend will now be 12% on £600,000

35,000 24,000

£59,000

£72,000

Few additional funds have been introduced to generate further profits. This may cause a fall in the market price of the shares.

Loan Repayment

Where a company borrows money on the understanding that this will be repaid, provision should be made to ensure that funds are available on the due date. Even though a company is earning profits the cash equivalent may have been invested in assets and is not available for distribution to debenture holders.

The trust deed under which the loan was raised will specify the method of repayment, e.g. on a particular date, over a period of time or by purchase on the stock market as the holders make them available. Where repayment is on a fixed date the company may obtain the funds either by a new share issue or the raising


of a further loan. In the former case a change in the structure will have taken place. As a result the fixed interest payable, irrespective of whether the company earns profit or not, will be replaced by the ordinary dividend payable whenever profits are available. The rate of dividend may well be higher than the interest rate. Where repayment is from a new loan the interest will be at a higher rate than on the original loan with consequent effect on profit available for shareholders.

The Companies Acts do not lay down any regulations regarding debenture repayment as they do for Redeemable Preference Shares and it is therefore incumbent on companies to make the necessary arrangements prior to the date of repayment. This may be done by investing funds outside the business for the sole benefit of the debenture holders; the investments being sold as funds are required. The company at the same time must consider the rights of other creditors and must therefore restrict its dividend to the shareholders.

A company earning a profit of £20,000 shows the following Balance Sheet:

Fixed Assets Stock Debtors Bank

Share Capital Profit and Loss Debentures Creditors

220,000 80,000 30,000 30,000

£360,000

200,000 30,000

100,000 30,000

£360,000

The company has three alternatives: (1) declare and pay a dividend of 15%; (2) pay creditors; (3) purchase investments, thus retaining funds for debenture holders.

In order to prevent alternatives (I) and (2) the debenture trust deed will probably specify that a fixed sum is to be set aside out of profits to restrict dividend declaration and also require the equivalent cash to be invested.

When the debentures are repaid the profits retained become available to the shareholders, but only in the form of bonus shares as the corresponding cash has been used to repay the debenture.

A company has issued £500,000 4% debentures to be repaid at the end of twenty years and is to invest £25,000 per annum, transferring a similar amount to reserve.


Bank

Bal. (say) 30,000 Purchased lnvestmts. 25,000

Profit and Loss

Trans. Bal. (say) 40,000 to Reserve for Debenture Rdemptn. 25 ,000

Debenture Investment

Bank 25.000 I Reserve for Debenture Redemption

Trans. 25,000

At the end of 20 years the position will be: Investments Reserve

Bal. 500,000 I The investments are sold and the debenture repaid:

Bank

Sale Debenture of Holders 500,000 Investmts. 500,000

Reserve for Redemption of Debentures

I Bal. 500,000

Debenture

Cash Bal. Repaymt. 500,000

Investments

Bal. 500,000 I Bank

500,000

500,000

500,000

If the reserve is now transferred to capital and the same total dividend is paid there will be a fall in the rate, or if the rate is maintained additional profits will have to be earned.

The example ignores the question of repaying the debenture at a premium or selling the investments at a profit or loss. The premium and losses may be charged to the reserve, profits being credited. Any interest on the investment will be similarly credited and if the interest is subsequently invested will enable the annual charges to be reduced. The actual amount of annual investment under such conditions is determined by reference to actuarial tables.

A company has in issue a £200,000 debenture, repayable at the end of five years, and decides to invest £32,760 annually at 10% to ensure availability of funds on the due date.

Bank

End, Yr. 2 Interest 3,276 End, Yr. 1 Purchase of Investmts. 32,760

3 " 6,880 2 " 36,036 4 " 10,844 3 " 39,640 5 " 15,204 4 " 43,604

5 " 47,964


Investments

Yr. 1 Bank 32,760 2 Bank 36,036

68,796 3 Bank 39,640

108,436 4 Bank 43,604

152,040 5 Bank 47,964

£200,004

There is no necessity to undertake the investment at the end of the fifth year. The investments costing £152,040 can be realised and the interest in the fmal year withdrawn from the bank together with the annual instalment of £32,760.

The investment of funds has no relationship to profits which could still be distributed if cash is available. To prevent such a possibility the corresponding sum must be transferred to reserve together with any interest on the investments. This is not credited to the Profit and Loss Account due to the fact that owing to reinvestment of the interest the annual charge to the Profit and Loss has been reduced.

Reserve for Redemption of Debentures

Yr.l Profit and Loss 32,760 2 Interest 3,276

Profit and Loss 32,760

68,796 3 Interest 6,880


108,436 4 Interest 10,844


152,040 5 Interest 15,204


£200,004

On realisation of the investments any profits or losses can be transferred to the reserve and on repayment of the debenture the reserve becomes available for distribution in the form of bonus shares to the shareholders.


The £200,000 debenture is repaid at a premium of 3%, the investments being sold for £207,000.

Balance Profit to Reserve

Bank

Investments

200,004 6,996

£207,000

Cash Sale Proceeds

Debentures

206,000 Balance Premium to Reserve

£206,000

Reserve for Debenture Redemption

Premium on Debentures

Balance (Trans. to Cap. Reserve and converted to shares when convenient)

Questions

6,000 201,000

£207,000

Balance Profit on Sale of Investmt.

207,000

£207,000

200,000 6,000

£206,000

200,004 6,996

£207,000

7.1 A company was formed with an authorised capital of £350,000 in ordinary shares of SOp each. 200,000 shares were issued to the public at 70p and these were all taken up. Show the relevant accounts.

7.2 A company with an authorised capital of £500,000 in shares of 30p each proceeded to issue 500,000 shares at a price of 60p. All the shares were subscribed for. The issue was underwritten at 3%. Show the relevant accounts.

7.3 A company with an authorised capital of £600,000 in shares of 20p each issued 700,000 shares at a price of 90p. 1,200,000 shares were subscribed for. Underwriting commission was 4%. Show the relevant accounts.

7.4 A company whose authorised capital was £700,000 comprising 500,000 ordinary of £1 and 200,000 8% preference shares of £1, issued 300,000 ordinary shares at 1.70p each and 100,000 preference shares at £1.20 each. Applications were received for 700,000 ordinary and 150,000 preference shares.

Issue expenses, not including Underwriting Commission, were £12,800. The issue was underwritten at 4%. Show the relevant accounts and a Balance Sheet.


7.5 M. L. Finance Co. Ltd produces the following Balance Sheet:

Ordinary Share Capital

5% Redeemable Preference Shares


General Reserve

220,000

140,000

30,000 180,000

£570,000

Fixed Assets Investments Bank

400,000 80,000 90,000

£570,000

The preference shares are to be redeemed at a premium of 3%. In order to obtain part of the funds required the investments were sold at a profit of £3,500.

You are required to show the necessary accounts recording the above transactions, together with a Balance Sheet on completion.

7.6 M.J.R. Ltd was registered with an Authorised Capital of £500,000 comprising 300,000 ordinary shares of SOp each and 350,000 preference shares of£1 each.

The company issued a Prospectus offering all the ordinary shares at a price of 80p and 200,000 of the preference shares at £1.10 each. All amounts due were payable in full on application.

The issue was underwritten at 3%.

The ordinary shares were heavily oversubscribed and the company proceeded to allotment as follows:

Applications Total shares Basis of applied for allotment

Under 200 shares 55,000 Nil :200 - 499 Shares 100,000 In full 500 - 999 Shares 400,000 30% I ,000 and over 200,000 40%

The preference shares were only taken up to the extent of 60% of the offer, the remainder being allotted to the underwriters.

Formation Expenses amounted to £7,500. Issue Expenses, excluding underwriting commission, were £9,400.

Write up the relevant accounts to give effect to the above transactions and prepare a Balance Sheet on conclusion of all transactions.

Long-Term Finance: Share Capital and Debentures 16 7

7.7 In 19---0 Blue Sky Ltd issued at par 4,000 6% debentures of £10 each which were immediately paid up in full.

Debenture interest is payable half-yearly on 30 June and 31 December, and the interest due on 31 December 19-8 was paid on that date.

A sinking fund has been built up by appropriations out of profits.

On 1 January 19-9 the following balances appeared in the company's ledger:

6% Debentures £40,000 Sinking Fund £25 ,500 Sinking Fund investments (at cost)

£25,500

On 31 March 19-9 investments which had cost £8,720 were sold for £7,900. On the same day the company purchased in the open market 800 of its own debentures for £7,900 (inclusive of accrued interest). These debentures were immediately cancelled.

You are required to show the entries in the relevant accounts in the company's ledger, to record the transactions of 31 March, and bring down the balances on the debenture account, the sinking fund account, and the sinking fund investment account.

7.8 The Balance Sheet of a company was as follows:

7% Redeemable Preference Shares of £1

Ordinary Shares of £1 General Reserve Profit and Loss

Current liabilities

120,000 280,000

80,000 226,000

706,000 127,000

£833,000

Fixed Assets Current Assets Bank

429,000 200,000 204,000

£833,000

The preference shares were redeemed at a premium of lOp each. 150,000 7lh% debentures were issued at a price of98. Show the necessary ledger accounts including cash, to record the above transactions and a Balance Sheet on completion.


7.9 The summarised Balance Sheet of A.C. Ltd, as on 31 March, was as follows:

Issued Share Capital: 40,000 6% Redeemable Pref. shares of £1 each, fully paid (redeemable on 29 April, at a premium of lOp per share)

60,000 Ordinary shares of £1 each fully paid

Share Premium Account Profit and Loss a/c Creditors

40,000

60,000 20,000 23,000 52,100

£195,100

Goodwill Preliminary exps. Sundry assets Balance at bank

7,000 2,850

158,000 27,250

£195,100

As part of the arrangements to effect the redemption of the preference shares of 29 April it had been decided to provide for the redemption of that part of the shares in issue which could not be otherwise redeemed, by an issue of new preference shares. Before doing so it had, however, been decided to write off the goodwill, preliminary expenses and discount on debentures (referred to below) but in such a way that the number of new shares to be issued should be the minimum possible.

The transactions during April were:

(1) On 4 April the company issued for cash £12,000 7% debentures at a discount of 2~%. (2) On 6 April the goodwill, preliminary expenses and discount on debentures were written off. (3) On 12 April the company issued at par, for cash (paid in full on allotment), the minimum number of new shares of £1 each necessary to provide for the redemption of those preference shares in issue which could not otherwise be redeemed. (4) On 29 April the company redeemed the 6% preference shares together with one month's dividend thereon. (5) On 30 April the company made a bonus issue to the ordinary shareholders of one fully paid ordinary share of £1 for every five shares held.

You are required to set out, for the information of the directors, a pro forma summarised Balance Sheet of the company as it would appear immediately after completion of the above transactions. Ignore taxation and expenses.

CHAPTER 8

Capital Structure and Valuation

Considerations of raising fmance - Capital Gearing

The promoters and subsequently the brokers of a company are required to bear in mind a number of factors when their company requires funds, both from the point of view of the investor and of the company. These might be summarised as in Table 8.1:

Ordinary shares

Dividend based on available profits

Non-payment of dividend will depress market price

No repayment of capital by company (unless company wound up)

If capital not fully utilised, company may be paying dividend in excess of return on capital employed

Table 8.1

Preference shares

Dividend at a fixed rate will accumulate if not paid

Non-payment will only marginally affect price; may have side effect on ordinary share price

May be repayment if of a redeemable class; will involve a new issue or depletion of funds

Rate of dividend may be below rate of return on capital employed

Debentures

Interest at a flxed rate is a charge on profits Non-payment will lead to appointment of manager acting on behalf of debenture holders until arrears paid

Repayable at a specified date - if not repaid, debenture holders can seize assets and sell off at any price to the detriment of other investors

Rate of interest probably below rate of return on the funds invested


If the company has issued an excess of loan and fixed dividend funds in relation to ordinary capital this may have an adverse effect on ordinary dividend movements and the level of profits required to meet the fixed charges.

The capital structure of two companies is as follows:

Ordinary Shares of £1 5% Redeemable Preference Shares of £1 8% Debentures of £100

Company A

6,000,000 3,000,000 1,000,000

Company B

1,000,000 5,000,000 4,000,000

£10,000,000 £10,000,000

Company A has a low-geared capital structure. Excessive movements in profits will have little effect on percentage movements in dividends - the two will remain in line.

Company B has a highly geared capital structure and minor movements in profits will have a more than relative percentage movement in ordinary dividend - the two will not move in conjunction with each other.

Profits required to meet fixed charges:

8% on 1,000,000 5% on 3,000,000

80,000 150,000

230,000

8% on 4,000,000 5% on 5,000,000

320,000 250,000

570,000

Company B is required to earn almost 2~ times the profit of A before being in a position to declare an ordinary dividend. If a dividend of 10% is required company A will require a total of £830,000 profits whilst company B will require £670,000. Company A, however, can suffer a 20% drop in profits and still pay 8~% ordinary dividend. A similar fall in profits of company B will, however, eliminate the ordinary dividend and also leave arrears of the preference dividend.

Profits, Yr. 1 Debenture Interest Preference Dividend

80,000 150,000

Company A

830,000

230,000

Available for Ordinary Dividend £600,000 = 10%

320,000 250,000

CompanyB

670,000

570,000

£100,000 = 10%

Capital Structure and Valuation 1 71

Company A Company B

Year 2: 20% fall in profits Profits 664,000 536,000 Less fixed charges 230,000 Less Debenture Interest 320,000

Available for Ordinary Available for Preference Dividends £434,000 Dividends £216,000

Representing 7U!% Required 250,000 a fall of approx. 20% Arrears £ 34,000

Year 3: A futher fall of 10% Profits 597,600 482,400 Fixed Charges 230,000 Less Debenture Interest 320,000

Available for Ordinary Available for Preference Dividends £367,600 Dividends £162,400

Representing 6% Required (250,000 + a fall of approx. 10% 34,000) 284!000

Arrears £121,600

Year 4 : Increase in profits of 30% Profits Fixed Charges

Available for Ordinary Dividend

Representing an increase of

776,880 627,120 230,000 Less Debenture Interest 320,000

£546,880 Available for Preference 307,120 Dividend

9% Required (250,000 + 121,600) 50% 371,600

Arrears £ 64,480

Even though profits have practically reached year 1 level an increase of 65% over year 3 will be needed to clear preference arrears and pay a 10% ordinary dividend. Profits, Yr. 3

+ 65% approx.

Debenture Interest

Preference Dividend (250,000 + 121 ,600)

Ordinary Dividend

Retained

482,400 313,500

795,900 320,000

475,900 371,600

104,300 100,000

£ 4,300


Company A will be in a position to raise either additional preference capital or debentures, since both classes of creditors will appreciate that they are fully covered by current profits. Ordinary shareholders will be aware that any additional funds they subscribe will be used to generate additional profit. Their dividends are not at risk. Profits can fall 90% on year one before debenture interest is at risk.

Company B will have difficulty in raising funds of any description as ordinary shareholders see no return. Preference shareholders understand that a relatively small fall in profits 15% leaves their dividend in arrears, whilst debenture holders know that the ordinary capital employed is required to earn 32% to cover their interest and a 53% fall in profits will leave their interest in arrears, using year one basis.

Capitalisation of Profits

Investors in shares of a company anticipate a return on their capital by way of a dividend out of revenue profits paid in cash. The company may, however, have utilised the profit represented by cash for the purchase of fixed assets.

The company may at the same time have accumulated profits which by law they are not allowed to distribute in cash, e.g. share premiums, even if the cash is available, or they are profits not represented by available cash, e.g. capital reserve arising on revaluation of assets.

Other forms of non-distributable profits, in cash, are Capital Redemption Reserve Fund, Debenture Redemption Fund and pre-acquisition profits.

Where a company has such profits available a return to members can be made by the issue of what are termed bonus shares. The member makes no payment for these shares and is able, if he so desires, to sell these shares in the market, subsequently obtaining cash which represents a return on his original investment.

The issue of shares without payment of cash will have the effect of bringing the share market values into line with asset values and at the same time conserves the cash resources of the company. The issue may also serve to simplify the capital structure of the company.

The Balance Sheet value, nominal value and market value may be more closely related as the result of a bonus issue and at the same time the shares may become more marketable due to their lower price.

A further effect of a bonus issue may be a lowering of the rate of dividend which may not meet with market approval and may lead to a fall in market price. The rate of dividend paid on share capital will, howev~r, more nearly represent a return on capital employed. For example:

Share Capital Capital Employed Dividend Paid

= 4*% on £1,560,000

£480,000 in £1 shares £1,560,000 15%£72,000

Note that of the capital employed £1,080,000 was represented by retained profits of which £960,000 can be utilised by the bonus issue.

Capital Structure and Valuation 173

If the company makes a bonus issue of two shares for every one held the position is:

Share Capital (£480,000 + £960,000) Capital Employed Dividend Paid

= 5% on capital, 4*% on capital employed.


Ordinary Share Capital 600,000 shares @ 40p

Share Premium CRRF Profit and Loss

Balance Sheet

£440,000 340,000

£780,000

240,000 130,000 260,000 150,000

£780,000

The shares have a Balance Sheet value of £1.30: Total Assets £780,000

Shares 600,000

£1,440,000 £1,560,000

72,000

with a market value of, say, 75p in view of the absence of dividends. The company can convert the retained profits into capital by the issue of

shares to the members for which they will not be required to make a payment. The members are receiving scrip, which will increase their holding.

If the company decides to issue two additional shares for every one held the nominal value of such issue would be £480,000 and the Share Premium and CRRF can be utilised together with £90,000 from the Profit and Loss Account.

Accounting entries:

Capitalisation

Capitalisation

Capitalisation Balance

Share Premium

130,000 Balance

Capital Redemption Reserve Fund

260,000 Balance

Profit and Loss

90,000 60,000

£150,000

Balance

Balance

130,000

260,000

150,000

£150,000

60,000


Transfer to Capital Scrip Issue

1 ,200 ,000 Shares @40p


Ordinary Capital

Capitalisation

480,000

£480,000

Share Premium Capital Redemption Profit and Loss


I Bolance Scnp Issue

Balance Sheet (after issue)

440,000 340,000

£780,000

1 ,800,000 Shares @ 40p Profit and Loss Account

720,000 60,000

Shares are now worth 43p:

£780,000

Assets £780,000 Shares 1 ,800 ,000

130,000 260,000 90,000

£480,000

240,000 480,000

£720,000

with a market value of, say, 22p resulting from the additional shares coming on to the market and a possible fall in the rate of dividend.

Dividend policy

Assume the company was paying 15%, which required annual profits of £36,000 (15% of £240,000). To maintain a 15% dividend will now require £108,000 (15% of £720,000) when the capital increase has not generated any additional funds. The profits previously earned will only enable a dividend of 5% to be paid:

£36,000 X 100

720,000 and whilst this rate will be on three times the number of shares, the market is concerned with the rate of dividend as compared with competing companies.

A bonus issue indicates to members that profits have been ploughed back into the business. Whilst, as shown above, the market price may fall, making the shares easier to purchase, it will be necessary to purchase a larger quantity to gain control and there may be difficulty in obtaining the necessary number.


Rights issues

These issues arise when a company requires additional funds but wishes to restrict the issue to existing shareholders.

Members are informed of their rights on the basis of their existing holding, e.g. present capital 1,000,000 shares of £1 having a market price of £3.75. The company wishes to raise £800,000 and price the issue at £2.50 per share; they will therefore be issuing 320,000 shares. Members will be given the right to apply for 32 shares for every 100 held (or 8 for every 25).

The issue price will always be below market price as the company wishes existing shareholders to subscribe funds to the company and not to purchase on the market.

When members are sent details of their entitlement they will also be given the option of applying for additional shares, where the company is making a simultaneous public issue, or disposing of their rights to third parties. Members will not be selling their shares but disposing of the document authorising them to apply for shares (the rights letter).

The price of such rights is calculated as follows:

Cost of 100 shares at market price of £3.75 Cost of 32 shares at issue price of £2.50

Cost of 132 shares £455 Cost per s~are 132 Market pnce

Rights per share

£3.447 3.75

£0.303

£375 80

£455

A person taking over the rights· would pay 32 x £0.303 to the present shareholder and 32 x £2.50 to the company, a total of £90 - the market price of new shares should be £2.80. This method of pricing rights ensures that outsiders do not pay less than the market price.

After the tssue the normal market movements of supply and demand will affect the price as shareholders attempt to purchase additional shares or take a profit on their new shares.

A member who only partially takes up his right will set the proceeds from sale against cost of any entitlement:

Entitlement on present holding of 400 shares 128 Disposes of rights to 50 shares and receives 50 x £0.303 = Pays to company 78 shares at £2.50

Net cost for 78 shares Cost per share £2 .30

£15.15 195,00

£179.85

The accounting entries for a rights issue follow the procedure for a general capital issue. The company has increased its total capital with a minimal rise in the number of shareholders.

Apart from restricting the issue to present shareholders a rights issue has the advantages of economy in costs. The company is not involved in advertising and saves on administrative costs.

The effect on value of share can be seen as follows:


Before issue

Sundry Net Assets Capital £1 Ordinary Shares Retained Profits

£1,400,000 1,000,000

400,000

£1,400,000

Shares have a Balance Sheet value of £1.40 £1,400,000

1 ,000 ,000 shares

After issue

Sundry Net Assets Capital-Ordinary

£2,200,000 Shares now have a Balance Sheet value of £1.66

Shares of £1 Retained Profits Share Premium

320,000@ £1.50

1,320,000 400,000 480,000

£2,200,000

£2,200,000

1,320,000 shares

The value after issue will depend on the market movements in view of increase in supply. The effect on dividends will be:

Assume 15% of £1 ,000,000 15% of £1,320,000 =

Additional profits required

150,000 198,000

£48,000

representing a return of 6% on the additional capital raised of £800,000. If this is in line with present return the market price may well remain steady.

As compared with a bonus issue the additional shares represent additional funds for Llte company which should be utilised in the most profitable manner.

The price of a capital issue may be calculated on the basis of anticipated dividend as follows:

Balance Sheet


Ordinary Shares of £1 Reserves

2,640,000 480,000

£3,120,000

2,400,000 720,000

£3,120,000

The shares have a Balance Sheet value of:

£3,720,000 = £1 30 2,400,000 '

The company intends to raise £600,000 either by a public issue or a rights issue on a 1 for 5 basis. A dividend of £540,000 will be paid on the total capital after the issue. The market expects a return of 12%.

The anticipated dividend represents a return of 18%:

£540,000 X 100

3,000,000


It has been assumed that the issue is at par. The value of the share is

. Actual Rate Nommal value x Market Rate = £1 x ~- = £1.50

The price of the rights issue would be:

Capital required £600,000 = £1.25 Shares to be issued 480 ,000

( Ysof2,400,000) The price of the rights letter would be:

Cost of 500 shares at market price £1.50 Cost of 100 shares at issue price £1.25

Cost of 600 shares

Cost of one share Market price

Rights price

750 125

£875

£1.458 1.500

0.042

The market price of the shares after the rights issue would be:

Market Value of Dividend Shares in issue

_ 540,000 X

- 12 100 = £1.56

The Balance Sheet after rights issue is: Fixed Assets 2,640,000 Current Assets 1 ,080 ,000

Ordinary Shares of £1 Shares premium Retained profits

£3,720,000

2,880,000 120,000 720,000

£3,720,000

2,880,000

The shares have a Balance Sheet value of

£3,720,000 = £1.29 2,880,000

The holder of 6,000 shares wishing to invest £1 ,500 irrespective of manner of issue would then have a holding valued at:

Original holding at £1 New Issue @ £1.50

Value per share

General Issue

Shares 6,000 1,000

7,000

Cost 6,000 1,500

£7,500

£1.07

New Issue @ 1.25

Rights Issue

Shares 6,000 1,200

7,200

Cost 6,000 1,500

£7,500

£1.04


The reduction in value per share is offset by increased holding. The value will also be affected by market movements on a supply and demand basis.

The above calculation should be compared with the effect on share value after a bonus issue.

Table 8.2 illustrates the prices at which a number of leading companies issued capital under a rights issue at a time when it was considered that, du~ to the state of the money market, a public issue may not have been successful.

TABLE 8.2

Industry Capital Issue Issue Market Change Rights Antici-raised basis price price on day price pated div-

per idend share per

share

£m. p p p

Mining 35.5 1 for 8 £1.25 £1.57 - 7 3.5 5.6 Insurance 31.6 1 for 4 1.30 1.73 + 5 8.6 7.75 Electrical 15 1 for 4 80p 1.05 -11 5 3.9 Dairy Farmers 12.5 1 for 5 39p 48* N/C 1.6 Chemicals 6.8 1 for 5 90p 1.06 - 8 2.66 5.5 House builders 2.8 1 for 3 60p 92 + 8* 8 6 Chemicals 2.7 1 for 3 88p 1.25 + 6 9.25 7

Share valuations

Promoters and brokers have attempted to price shares when making capital issues by taking into account future prospects of the company, the state of the money market and the type of business.

Investors, however, apart from buying shares at the time of issue, may wish at some later date to purchase sufficient shares to obtain a controlling interest and such persons will be concerned with the state of the assets, the profit-earning capacity of the business and the alternative uses to which such assets might be put or the necessity for replacement giving rise to additional depreciation charges thus reducing profit.

In the simplest form, shares can be valued on the basis that if all assets are disposed of and liabilities paid off the remaining funds will be distributed among the ordinary shareholders.

This method, known as the 'Assets Basis' {Balance Sheet Valuation), acknowledges that any undistributed profits are represented by assets owned by the ordinary shareholders.

Balance Sheet



£1 Ordinary Shares 6% Preference Shares Retained Profits 8% Debentures

3,200,000 2,600,000

5,800,000

1,300,000

£4,500,000

1,800,000 1,700,000

540,000 460,000

£4,500,000


If assets are sold at Balance Sheet valuations proceeds are 4,500,000 from which would be deducted amounts due to Debenture Holders

460,000 Preference Shareholders

1,700,000

Leaving

2,160,000

£2,340,000

available for ordinary shareholders to give a valuation of

£2,340,000 shares= £1.30 1,800,000

Such a valuation is, however, unlikely to arise due to the historical nature of the Balance Sheet and the valuer requiring an up-to-the-minute situation. The above example serves to illustrate the point that ordinary shareholders consider that surplus assets reflect the growth of their shares through undistributed profits and they require compensation when an offer is made for their shares.

The sellers of a business will attempt to put the business in the best possible situation and therefore revalue the assets according to current market prices. The position is then as follows:

Fixed Assets as revalued

Current Assets as revalued

Less Debenture Holders 460,000 Current Liabilities 1,300,000 Preference Shareholders 1,700,000

Leaving

4,460,000

2,420,000

6,880,000

3,460,000

£3,420,000

This gives a valuation of £3,420,000 = £1 90

1 ,800,000 shares · The price at which the business is bought and sold then becomes a matter for discussion between the parties. The valuation of shares is basically a discussion of opinions, each party attempting to obtain the best bargain.


Normal market dealings involve the deduction or addition of a quarter of the difference between two prices, as follows:

Buyer is offering 1.30 Seller hopes to obtain 1.90

Difference 60~ == 15p Buyer may lift price to 1.45 Seller may reduce price 1.75

Difference 30~ == 7.5p Buyer may lift price to 1.52 Seller may reduce price to 1.67

Difference 15~ == 4p Buyer now offers 1.56 Seller now offers 1.63

Bargain probably struck at £1.60

Where assets are, due to economic use, extremely profitable the seller may attempt to obtain a price on the basis of profits representing a return on capital, and such profits represent a dividend at a given rate or for a specified number of years.

This method is referred to as the 'Profit Basis' and acknowledges that an investor is aware of the return he is expecting on his capital or the number of years he expects to work before seeing capital repaid.

If profits in a particular financial period are £496,800 and this is a 12% return on capital, the capital value is calculated as

£496,800 X 100 12 == £4,140,000

giving a value per share of:

£4,140,000 = £2 30 I ,800 ,000 shares ·

The purchaser, however, will wish to examine the Profit and Loss Account to discover any omissions or extraordinary charges or credits not likely to arise if he purchases, e.g. income from investments, write-offs in respect of obsolete stock, additional depreciation arising from replacement of fixed assets, economies arising from elimination of expenses.

Changes in profit levels will also have an effect on taxation charges and amounts available for dividends.

The valuation may also be attempted on the basis of the average profit for a given number of years. This may ignore fluctuations leading to an average which has no relationship to normal profit.

A share price may also be calculated by reference to the dividend paid as a percentage of the market price of the share.

This method is referred to as the 'Dividend Yield' and acknowledges that an investor may be satisfied with a lower rate of return, or is anticipating a higher rate than is paid by the company.


A company whose shares have a nominal value of £1 pays a dividend of 15%. The market value is £1.25. The dividend represents a return of 12%

15 X 100 125

alternatively the price to be paid may be calculated by considering the expected income on the nominal value with the actual income:

Nominal value £1 Actual dividend 15%

15 X 100 20

Expected dividend 20% 75p The price the investor would pay.

If actual dividend is 25% and expected dividend is 20% price would be:

25 X 100 = £1.25 20

This method is useful when attempting to compare the market price of a number of shares of differing nominal values. For example,

N.Y. SOp Dividend 10% M.Y. 80p Yield Sp X 100 = 614% 80p

N.Y. £1 Dividend 18% M.Y. 1.90 Yield 18px100_

9~% l90p

N.Y. 25p Dividend 20% M.Y. 30p Yield Sp X 100 = 16%% 30p

The profit earned per share may also be used to determine the period required to obtain the return of the capital by ascertaining the extent to which the market price exceeds the earnings. This method, Price/Earnings Ratio, acknowledges that investors realise that capital may only be recovered after a given period and each investor is aware of the period he is prepared to wait. For example,

Earnings lOp M.Y. 75p P/E Ratio 71/z Earnings 25p M.Y. £3.00 P/E ratio 12 Earnings 30p M.Y. £6.00 P/E ratio 20

Investors in these companies, paying present market prices and on the basis of present earnings, will appreciate that they will not obtain return of their capital for 71/z, 12 and 20 years, respectively.

Conversely, an investor knowing the period he requires will convert the earnings accordingly. For example,

Earnings lOp P/E rato required 6 :. Price 60p Earnings 25p P/E ratio required 10:. Price 2.50 Earnings 30p P/E ratio required 15 :. Price 4.50

Negotiation will now take place on the basis of buying price 60p and selling price 75p: £2.50 and £3.00, £4.50 and £6.


The above methods have operated for the valuation of shares in public companies where there is no restriction on transfers and the market dealings give an indication of a price.

In the case of the purchase of shares in private companies the following considerations must be borne in mind:

Assets - Lack of capital may have prevented replacement; considerable expenditure may be necessary.

Profits - May be affected by the absence of salaries taken by way of dividends.

Dividends - May have been affected by the necessity to retain funds. Owners of a private company may take dividends by way of salary.

Price/Earnings - Is not applicable due to lack of market - any comparison with comparable public companies is artificial due to dissimilar size of businesses and the absence of the market attempting to fix prices.

In addition the Articles of Association may contain restriction as to the method of buying and selling; for example, they may require the purchase of a minimum quantity or sanction of remaining members.

Factors affecting share price

(1) Necessity to sell, executor obtaining funds- price falls. (2) Extent to which buyer attempting to obtain control - price rises. (3) Capital gearing, extent of fixed charges depressing dividend -price falls. (4) Profit to capital employed; is this in line with similar businesses? (5) Extent of fluctuations in profits. (6) Valuation of fixed assets, if giving rise to increase -price rises. (7) State of business generally, i.e. stock and debtor valuation - adequate

reserves. (8) Proportion of capital being purchased Oarge holding has more bargain

ing power compared to smaller holding) -price rises. (9) Rate of dividend compared to anticipated rate and rate for industry.

(1 0) Type of trade, if speculative - price falls. · (II) Dividend policy in relation to profits, if conservative- price falls.

The following case gives an indication of the problems involved in attempting a share valuation.

Balance Sheet £000's

Land and Buildings 45 Plant and Machinery 783 Investments Current Assets

Stocks 3,055 Debtors 1,698 Bank 1,111

£5,864

Current liabilities Creditors 2,934 Proposed Dividend 24 Bank Overdraft 957

£3,915

Ordinary Shares of £1 6*% Preference Shares of £1 Retained Profits

Taxation Insurance Premiums

828 438

1,949 £3,215

698 139

1,652

2,489 564 162

£3,215 --


Company had maintained a dividend of 5% for 20 years. Profits after tax for past five years:

Yr. 1 97,000 2 103,000 3 62,000 4 27,000 5 58,000

Prices offered or quoted Buyer Seller

56¥.! £1 62* £3 75 £1.70 80 £1.40 88 £1.20

Final price 1.20

88

Margin 32 ¥.! = 8 Result 88 + 8 = 96p

On Balance Sheet ordinary shares were worth

Less Preference Capital

3,215,000

139,000

£3,076,000 = £4.40 approx. 698,000

If a further deduction is made for taxation and insurance the value is:

3 076 000 - 726 000 = 2•350•000 = £3 36 ' ' ' 698,000 .

The following views were expressed during negotiations over price:


Buyer

Trade extemely risky. Current asset position not

satisfactory. Stocks excessive. Overdraft at too high a level. Profits result of inflation

and were abnormal. If prices fell stocks were

at risk. Company was a family business,

buyer might have difficulty in reselling.

Able to purchase less than 10% -little possibility of getting control.

Capital replacement costs excessive.

Seller

Assets profitably employed. Not worried by size of overdraft -

a healthy sign of asset management.

Prices would not fall.

If company was going public, purchaser would not be restricted.

Buyers were depressing price on fears of speculation if company went public.

At £1.20 would buy every share available if this was view of previous valuer.

As a result of discussions the price of the shares was finally agreed at 95p each. Business was a family concern, they did not want to lose control. Share could only be transferred to non-members at a fair valuation.

You are required to place a value on the shares.

Balance Sheet

Fixed Assets Net Current Assets

Share Capital of £1 Reserves

300,000 Fixed Assets purchased 3 years 600,000 previously are valued at cost less

£900,000 depreciation amounting to £100,000 p.a.

100,000 800,000

£900,000

Current market value £1,050,000. Scrap value in 5 years 50,000. Cost of replacement will then be £1,200,000.

Your client takes a salary of £6,000 p.a. and a dividend of £300,000 p.a. which was the profit for each of the past 3 years. A replacement as manager will require £9,000 p.a. Investors normally expect a dividend yield of 10%.


Assets per Balance Sheet Add profit on revaluation of fixed assets (£1 ,050,000 - 300,000)

Add premium in respect of actual earnings compared with anticipated earnings. Actual dividend Anticipated dividend

10% on £900,000

for say 3 years

Ordinary Shares Value per share

Assets after replacement Add sum in respect of actual earnings exceeding anticipated earnings. Present profit before salary and depreciation (300,000 + 100,000 + 6,000) Less future salary and depreciation (Depn., (say), 150,000 + 9000)

Anticipated income 10% on 1 ,800,000

for say, 3 years

£300,000 90,000

210,000

406,000

159,000

247,000

180,000

67,000

Ordinary Shares Value per share

900,000

750,000

1,650,000

630,000

£2,280,000

100,000 £22.80

1,800,000

201,000

£2,001,000

100,000 £20.Ql

Seller is saying assets should be revalued but this does not involve buyer in any additional funds - he only expects a return on cost of assets. Present income is profit after charges.

Buyer considers he has to find funds for replacement, which affects his anticipated return. Profit accruing to him by way of dividend will be reduced by virtue of increased depreciation. (Cost £1,200,000 over estimated life of 8 years -present assets 3 years old, have 5 years to run.)


Profits at present time:

Dividend Depreciation Salary

Less future charges Depreciation (300,000- 50,000 + 5 years) Salary

Profits available as dividend

Representing 10% return Capital value is Value per share

Profits after replacement Present profits before depreciation and salary Less future depreciation (£1 ,200,000 + 8 years Salary

Profits available as dividend

Capital value@ 10%

Value per share

300,000 100,000

6,000

50,000 9,000

150,000 9,000

406,000

59,000

£347,000

3,470,000 £34.70

406,000

159,000

£247,000

£2,470,000

£24.70

Seller argues that future profits not affected by revaluation - there are no capital costs to be written off. Future profits will be increased by virtue of reduced depreciation.

Buyer argues that at point in time when assets replaced an increased depreciation charge will arise in addition to increased executive charges. Even if depreciation calculated on revaluation figure this will bring profit to £197,000 (£1 ,050,000 - £50,000 + 5 years = £200,000 p.a.) or if written off over 8 years will give £125,000 p.a. for a profit £272;000 (share value £27 .20).

Comparative figures, therefore, are:

Minimum Maximum

Final price probably in the region of £24.

Seller

22.80 34.70

Buyer

20.01 27.20


Questions

8.1 The Balance Sheets of two companies are as follows:

ABC Ltd XYZ Ltd

3% Redeemable Preference Shares of £1 soo,ooo soo,ooo

Ordinary Shares of SOp 280,000 280,000 Retained Profits 306,000 S66,000 Creditors 114,000 14,000

£1,200,000 £1,360,000

Fixed Assets 429,000 7SO,OOO Current Assets 461,000 280,000 Bank 310,000 330,000

£1,200,000 £1,360,000

The Preference Shares are redeemable by both companies at a premium of 10%.

ABC Ltd decides to make an issue of SOp Ordinary Shares, at a price of SSp, sufficient to cover the cost of repaying the Preference Shares.

XYZ Ltd raised an issue of 10% Debentures (secured on the Fixed Assets) at a price of98p.

Both companies subsequently made a bonus issue on a 1 for 4 basis.

In the previous two years both companies had paid an Ordinary Dividend of 12%% after meeting Preference Share dividends.

You are required to show the Balance Sheets of both companies on completion of all the above transactions, and to comment on the merits or otherwise of both schemes.

8.2 The 'capital and reserves' section of the published Balance Sheet of Eagle Boatbuilders Ltd, as at 31 December, 19-2 was as follows:

Authorised Capital S,OOO,OOO Ordinary Shares of £1 each

Issued Capital 2,000,000 Ordinary Shares of £1 each fully paid

Reserves Capital Reserve Capital Redemption Reserve Fund Share Premium Retained Profits

1,SOO,OOO SOO,OOO 200,000 so,ooo

£S,OOO,OOO

2,000,000

2,2SO,OOO £4,2SO,OOO


The directors are anxious to increase the company's funds by £500,000 during 19-3. During the year, the company earns a profit of £400,000 {after providing £100,000 for depreciation). There have been no other sources and no applications of funds during the year, but the usual dividend of 20% has not been paid. As at 31 December 19-3, the Directors are considering the following changes in the company's capital:

either

or

(a) a rights issue on the basis of one share for each five already held at a premium of 25p

(b) a bonus issue on the basis of one share for each four already held. Required:

(a) Pro-forma Balance Sheet (capital and reserve section only) as at 31 December, 19-3 for each of the two alternatives, i.e. after making (i) the rights issue, (ii) the bonus issue.

(b) The maximum dividend the directors could declare in each case if their objective of increasing the company's funds by £500,000 is to be achieved. Explain how you calculate the maximum dividend in each case.

8.3 Fashion Ltd is a private company controlled by Smith, who is considering selling his interest in the firm. The summarised Balance Sheet of the firm at 31 December was as follows:



£1 Ordinary Shares Reserves Profit and Loss a/c

11,000 13,500

24,500 5,500

£19,000

10,000 4,000 5,000

£19,000

The company normally earned £3 ,000 per annum and paid a dividend amounting to £500. Smith had arranged that the business be professionally valued and the results showed the Current Assets to be worth £10,000 while the Fixed Assets were worth £17,500. However, these were under conditions of a forced sale for liquidation.


Smith also knew that similar private companies gave a yield of 10% on earnings, while the quoted public companies in the same field have a dividend yield of 4%.

Required: (a) To value an ordinary share on (i) liquidation or break-up basis, (ii)

dividend yield basis, (iii) earnings yield basis. (b) To comment briefly on the limitations of the valuations you have calcu

lated.

8.4 Explain the methods you would use when asked by a client to advise him on the price at which he should acquire a substantial holding of ordinary shares in the following private company. What are the limitations to the methods you have used?

Freehold land and Buildings, at cost Plant and Machinery, at cost

Less depreciation

Current Assets Stocks Debtors Bank

Current liabilities Creditors Taxation Proposed Dividends

8% Preference Shares of £1 Ordinary Shares of £1 Reserves 10% Debentures (secured)

362 76 24

102 30

202 354

84

640

462

60 120 84 60

£000's 74

72

178

324

324

Profits for the past three years, after tax and debenture interest but before dividends, have been £68,000,£76,000 and £35,400.

The freeholds are currently valued at £157,000. Plant is of a specialist nature with a value of only £25,000.

Public companies in the same trade as the above private company have a price/earnings ratio of 12 and a dividend yield of 10%.

CHAPTER 9

Reconstructions, Amalgamations and Consolidations of Company Accounts

Reconstructions

The situation may arise where a limited company wishes to reconstruct its capital in order to bring this into line with its assets position. The reasons for a reconstruction could include:

(1) The company has suffered substantial losses of funds either through poor trading conditions, failure of investments, losses of fixed assets such as a substantial fall in value below the cost of property, or the seizure of company assets by a foreign government.

(2) The capital gearing has become unsuitable for the profit-earning capacity of the company, such as a company having a high proportion of fixed interest capital or loan stock, the interest on which is greater than its ability to earn profits.

(3) To simplify the capital structure by reducing the number of classes of shareholder.

The procedure to carry out a reconstruction is governed by law. The accounting principles are given in Table 9.1.

Table 9.1 Accounting principles for a reconstruction

Where revaluation of assets takes place, transfer the losses to a reconstruction account.

Where there are accumulated losses on the Profit and Loss Account to be eliminated transfer these to the reconstruction account.

Dr. Reconstruction account

Cr. Sundry Net Assets


Cr. Profit and Loss account and reserves

Amount by which the assets are to be written down

Amount of losses being borne by shareholders

Where reconstruction costs or old formation expenses are being written off, transfer the amounts to the reconstruction account.

Where shares/debentures are to be converted into other shares

Amalgamations and Consolidations 191


Cr. Reconstruction expense account

Cr. Formation expense account.

Dr. Share or Debenture account

Cr. Reconstruction account


Cr. Share Capital

Losses to be borne

Cancellation of old capital, creation of new capital

Although these adjustments will affect the Balance Sheet figures the market value of the shares may not be affected because the market value is determined by economic conditions, comparative rates of investment return and asset values on disposal of the business. For example, prior to the reconstruction a share at a nominal value of £1 may have had a market value of £0.10. The result of areconstruction will be to reduce the nominal value to a figure nearer the market value.

Law Relating to Reductions and Reconstructions

The main sections of the Companies Act relating to this are Section 66-72 inclusive, the main points of which can be summarised as follows:

(1) A company may reduce its share capital provided the Articles of Association allow it. A special resolution has to be passed {21 days' notice; 34 majority) and the Court must approve the scheme.

{2) Where the reconstruction involves the reduction of the uncalled amount on shares or the repayment of capital to shareholders, every creditor, as listed by the Court, may raise objections to the scheme. It is an offence to withhold the name of a creditor from the Court.

{3) If the Court so decide, the words 'and reduced' may be added to the company's name.

( 4) The Registrar of Companies must be given copies of the minutes and the assent of the Court concerning the scheme.

{5) Where the rights of several classes of shares are to be changed separate meetings must be held for each class. More than 15% of the shareholding may raise objections with the Court if they did not vote in favour of the resolution.

Section 206. Majority of creditors representing * in value or a class of members can agree to a scheme of reconstruction and if the Court gives sanction to the scheme it is binding on all creditors and members.

Section 207. Effect of compromise to be notified to all creditors, members and debenture holders.

19 2 A Foundation in Business Accounting

Section 208. Where reconstruction involves an amalgamation of two or more companies the Court will provide for transfer of assets and liabilities, allotting of shares and debentures, and dissolution of old companies.

Section 209. If less than 10% in value of members have not agreed to reconstruct within 4 months of the offer, their shares can be compulsorily purchased.

XYZ Ltd had in recent years suffered several severe setbacks. The value of its freehold property had fallen well below the cost and its investments were in an overseas company which was seized by the government of that country without compensation. Poor economic conditions at home had resulted in trading losses. It had been decided to write off all the losses and convert the Preference Share Capital into ordinary shares, one new share for every two held. The ordinary shareholders were to receive one new share for every five held.

Balance Sheet

Freehold Property Fixtures and Fittings Motor Vehicles Investments Net Current Assets

Ordinary Shares Cumulative Preference

Shares Profit and Loss a/c

Reconstruction

300,000 8,000 6,000

35,000 12,000

£361,000

150,000

250,000 (39,000)

£361,000

F'hold Motors Invest-

1 70,000 Original capital I ,000 cancelled.

ment Pand L

a/c

Cum. Pref. 3 5 ,000 share-

holders 250,000 39 ,000 Ordinary

share-£245,000 holders 150,000

New Ord. Shares

To Cum. Pref. share-holders 125,000

To Ordinary share-holders 30,000

£400,000 £400,000

Bal.

Valuations

130,000 8,000 5,000

12,000

Freehold Property

300,000 Reconstruction 170,000

Bal. 130,000

£300,000

Bal. b/d 130,000

£300,000

Motor Vehicles

Balance 6,000 Recon-struction 1,000 Balance 5,000

£6,000 £6,000 --- ---

Balance 5,000

Ordinary Shares

Reconstruction Bal. £150,000

Bal.

£150,000


39,000 Reconstruction £39,000


I Reconstruction 155,000


Cumulative Preference Shares

Recon- Bal. £250,000 struction £250,000

Investments

Balance £3 5 ,000 Reconstruction £35,000

Fixtures and Fittings

Balance 8 ,000 I

Net Current Assets

Bal. 12.000 I

The Reconstructed Balance Sheet

Freehold Property Fixtures and Fittings Motor Vehicles Net Current Assets


130,000 8,000 5,000

12,000

£155,000

£155,000

Prior to reconstruction the market value of the ordinary shares may have been 20p and 80p for the preference shares in view of their greater dividend security and capital repayment.

Under the reconstruction the preference shareholders valued the ordinary shares at SOp whilst the ordinary shareholders accepted a valuation of 20p.

After reconstruction the shares have a Balance Sheet value of £1. Market value may well be approximately the same.

An ordinary shareholder who had 5,000 old shares valued at 20p (£1 ,000) now has a holding of 1,000 new shares valued at £1 (£1 ,000).

The value of the ordinary shareholding has remained the same, because the book value of the assets has been brought into line with their market value.

Met

hod

I

~----',

Met

ho

d//

~

Var

ious

Met

hods

of C

ompa

ny T

akeo

vers

and

Am

alga

mat

ions

Not

es

A t

akes

ove

r B

by

exch

ange

of

shar

es

and/

or c

ash.

The

inv

estm

ent

will

app

ear

on t

he B

alan

ce S

heet

of

A a

t co

st.

B re

mai

ns a

com

pany

but

con

trol

led

by A

. R

esul

t: B

is a

sub

sidi

ary

of

A. T

hey

rem

ain

two

sepa

rate

lega

l en

titi

es b

ut

the

shar

ehol

ders

of

A c

ontr

ol b

oth

com

pani

es.

A ta

kes

over

B b

y ex

chan

ge o

f sh

ares

. T

he a

sset

s of

B a

re t

rans

ferr

ed t

o A

and

B

is w

ound

-up.

Res

ult:

A b

ecom

es a

larg

er b

usin

ess

unit

and

the

re is

onl

y on

e le

gal e

ntit

y (C

ompa

nies

Act

s S

.20

6-8

and

287

app

ly).

A's

boo

ks:

B's

book

s:

Acc

ount

ing

Dr.

Inve

stm

ent

in l Amou

nt e

xcha

nged

to

subs

idia

ry

acqu

ire

the

shar

es in

B

Cr.

Shar

e C

apit

al/

Cas

h N

o ac

coun

ting

ent

ries

will

be

nece

ssar

y bu

t th

e re

gist

er o

f sh

areh

olde

rs w

ill b

e am

ende

d.

Tw

o m

embe

rs o

nly

repl

acin

g pr

evio

us m

embe

rs.

A's

boo

ks:

Dr.

Ass

et a

ccou

nt

} V

alue

of

net

asse

ts

Cr.

B L

td

assu

med

by

A L

td

Dr

B L

td

l Nomln

,J>

olu

"nd

C

r. S

hare

Cap

ital

/ pr

emiu

m if

any

of

shar

es,

Cas

h an

d ca

sh p

aid

to B

's Sh

are

Pre

miu

m

shar

ehol

ders

Dr.

/Cr.

Goo

dwil

l/

} D

iffe

renc

e be

twee

n th

e C

apit

al R

eser

ve

valu

e o

f ne

t as

sets

C

r ./D

r. B

Ltd

as

sum

ed a

nd t

he p

urch

ase

cons

ider

atio

n

B's

book

s:

Dr.

Rea

lisa

tion

l Book

nlu

o o

f no

t>=

t•

a/c

bein

g ta

ken

over

. C

r ./D

r. A

sset

s/

Lia

bilit

ies

Dr.

A L

td a

/c

) A

gree

d pu

rcha

se p

rice

C

r. R

eali

sati

on

a/c

Dr.

Res

erve

s }

The

und

istr

ibut

ed p

rofi

ts

Cr.

Sha

re C

apit

al

ofB

Ltd

...... ~

~ 6J ;:::

;::

f}

...... cs· ;:: ;:;· ~ "' s· ~ ~

~ 8 ;:::

;::

......

~-

Met

hod/

If

@]

Met

hod

IV

[~y'

',,@

A a

nd B

form

a n

ew c

ompa

ny, C

, w

hich

acq

uire

s al

l the

net

ass

ets

of

A a

nd B

in e

xcha

nge

for

shar

es.

A

and

B a

re w

ound

up.

R

esul

t:T

here

is a

new

bus

ines

s un

it, C

, cr

eate

d fr

om t

he o

ld f1

rms

A a

nd B

. The

sh

areh

olde

rs o

f C a

re t

he f

orm

er s

hare

ho

lder

s o

f A

and

B.

A a

nd B

form

a n

ew c

ompa

ny C

, whi

ch

exch

ange

s it

s sh

ares

for

tho

se i

n A

and

B

. A a

nd B

are

not

wou

nd u

p.

Res

ult:

C c

ontr

ols

A a

nd B

and

toge

ther

th

ey f

orm

a g

roup

of c

ompa

nies

. C is

kn

own

as a

'hol

ding

com

pany

'.

Dr.

/Cr.

Rea

lisa

tion

l a/

c C

r./O

r. S

hare

C

apit

al

The

pro

fit/

loss

on

the

real

isat

ion

of B

Ltd

whi

ch

has

been

cal

cula

ted

thro

ugh

the

real

isat

ion

a/c

The

ass

ets

rece

ived

in

sett

lem

ent o

f th

e pu

rcha

se

Dr.

Sha

re C

apit

al

} pr

ice.

The

ass

ets

are

Cr.

A L

td a

/c

dist

ribu

ted

to t

he s

hare

ho

lder

s in

an

agre

ed

prop

orti

on

The

sha

reho

lder

s o

f B

Ltd

will

gai

n ei

ther

a p

rofi

t or

suff

er a

lo

ss.

A L

td m

ay c

reat

e ei

ther

' Goo

dwil

l or

a c

apit

al r

eser

ve,

depe

ndin

g on

thei

r va

luat

ion

of

the

asse

ts a

cqui

red.

The

acc

ount

ing

trea

tmen

t is

exa

ctly

the

sam

e as

Met

hod

II

exce

pt t

hat b

oth

A a

nd B

are

wou

nd u

p an

d C

is c

reat

ed.

Whe

re v

aria

tion

s in

the

righ

ts o

f cr

edit

ors

or d

eben

ture

ho

lder

s ar

e to

be

chan

ged,

app

rova

l of*

of e

ach

clas

s in

va

lue

is n

eces

sary

tog

ethe

r w

ith

Cou

rt s

anct

ion

(Com

pani

es

Act

s S

.20

6-8

).

The

acc

ount

ing

trea

tmen

t is

sim

ilar

to M

etho

d I

exce

pt t

hat

C is

cre

ated

by

shar

e ex

chan

ges

wit

h bo

th A

and

B. T

he

Bal

ance

She

et o

f C w

ould

sho

w i

nves

tmen

ts in

sub

sidi

arie

s A

an

d B

equ

al t

o C

's c

apit

al.

The

rea

sons

for

the

cre

atio

n o

f a

hold

ing

com

pany

are

:-(a

) ad

min

istr

ativ

e co

nven

ienc

e; (

b) c

ost s

avin

gs w

hen

taki

ng

over

or

amal

gam

atin

g ot

her f~rms

-th

ere

is n

o ex

pens

ive

win

ding

up

to b

e ca

rrie

d o

ut a

s in

Met

hod

III;

(c)

ret

aini

ng

lega

l ide

ntit

y an

d co

mpa

ny n

ame;

(d)

gov

ernm

ent f

"man

cial

su

ppor

t; (

e) t

o ra

ise

extr

a fi

nanc

e by

'goi

ng p

ubli

c'.

The

val

ue o

f th

e sh

ares

bei

ng a

cqui

red

by C

will

be

arri

ved

at

by n

egot

atio

n an

d so

will

the

man

ner

in w

hich

tha

t val

ue is

to

be

sett

led,

e.g

. or

dina

ry s

hare

s, p

refe

renc

e sh

ares

, deb

en

ture

s, e

tc.

::t:. ~ ~

~ ~ ~ ~ 1::1 s.. g ~ ~

1::1 ... cs· ~ ...... ~


Amalgamations

The occasion may arise where a company wishes to form an alliance with another company: (a) to gain advantages from economies of scale, e.g. bulk buying; (b) to gain control of the source of supply or outlets for their products; (c) to diversify their operations; (d) to acquire additional working capital by acquiring a firm which has surplus funds; (e) to utilise surplus funds by acquiring a firm where the asset values are more than the total market value of the shares; (j) by government or economic pressure to fight off competition, e.g. government creations such as ICL or the GEC - English Electric merger.

Although these reasons may be sound practice for the absorbing company, much time and effort may be expended by both firms fighting the merger. The costs of the fight may exhaust both company's funds so that they have great difficulty in surviving; for example, Lines Brothers.

It must be emphasised that reconstructions take place through the books of both companies. In attempting problems of reconstructions and amalgamations, each set of books should be written up as a separate exercise. Confusion will arise if an attempt is made to close both sets of books simultaneously. No consideration should be given in the books of the selling organisation (vendor) to the values placed on the assets by the purchasing company.

Balance Sheet

A B

Fixed Assets Land and Buildings 3,000 Fixtures and Fittings 2,000 1,000 Vehicles 300 1,500

5,300 2,500 Current Assets

Stock 3,000 5,000 Debtors 2,000 1,500 Cash 1,500 2,000

6,500 8,500 Creditors 3,000 2,000

3,500 6,500 --

£8,800 £9,000 ---

Share Capital 9,000 2,000 Reserves (200) 7,000

£8,800 £9,000 --- --

The price for the companies was negotiated at A £15,800 and B £7,900 and was to be settled by the issue of £1 ordinary shares at par.

Amalgamations and Consolidations 19 7

C valued the assets and liabilities taken over:

Land and Buildings Fixtures and Fittings Vehicles Stock Debtors Creditors

A and B Cash A Cash B

Market Valuation

Books of A Ltd

Land Fixtures Vehicles Stock Debtors Cash Profit to Shareholders

Realisation Account

3,000 Creditors 2,000 Purchase

300 Price 3,000 c Ltd 2,000 1,500

7,000

£18,800

Reserves £1 Ord. Shares CLtd

Books of B Ltd Realisation Account

Fixtures 1,000 Creditors Vehicles 1,500 Purchase Stock 5,000 Price Debtors 1,500 c Ltd

3,000

15,800

£18,800

A

10,000 1,000

800 3,500 2,000

( 2,900)

£14,400

Reali sation

17,300 1,500 2,000

£20,800

CLtd

Or d. Shares

a/c £15,800 c Ltd

Share Capital

200 Bal. Profit on Reali-

15,800 sation

£16,000

2,000 Reali-sation

a/c 7,900

9,000

7,000

£16,000

CLtd Or d. Shares

£7,900 c Ltd

Cash 2,000 Loss to Share-holders 1,100

--£11,000 £11,000 --- ---

B

1,200 1,000 2,000 1,200

( 2,500)

£2,900

£15,800

£7,900


Share Capital

Loss on Bal. Reali- Reserves sation 1,100 Ord. Shares c. Ltd 7,900

£9,000 --

Books of C Ltd

A Ltd

Or d. Land Shares 15,800 Fixtures Creditors 2,900 Vehicles Capital Stock Reserve 100 Debtors

Cash

£18,800 --

Fixed Assets

10,000 Ord. 1,000 Shares

800 Creditors 3,500 2,000 1,500

---£18,800 ---

Balance Sheet C Ltd (After Amalgamation)

Land and Buildings Fixtures and Fittings (A 1 ,000 Vehicles (A 800 Goodwill (A-100

Current Assets Stock Debtors Cash

Creditors

£1 Ordinary Shares

(A 3,500 (A 2,000 (A 1,500

(A 2,900

+ B 1,200) + B 1 ,000) + B 3,000)

+ B 2,000) + B 1 ,200) + B 2,000)

+ B 2,500)

2,000 7,000

£9,000 --

BLtd

7,900 2,500

£10,400 ---

5,500 3,200 3,500

12,200 5,400

Fixtures Vehicles Stock Debtors Cash Goodwill

10,000 2,200 1,800 2,900

16,900

6,800

£23,700

£23,700

1,200 1,000 2,000 1,200 2,000 3,000

£10,400 ---

In the books of A Ltd and B Ltd the book values of the assets and liabilities are used to arrive at a profit for A and a loss for B, while in the books of C Ltd the valuation of the assets and liabilities is used. This, compared with the price, gives rise to a capital reserve on A and goodwill on B, these having been set off against each other to produce a goodwill figure of £2,900.


The premium on purchase, i.e. goodwill, represents the difference between the price paid by the purchasing company and their valuation of the assets.

Book Value A and B 17,800

Market Valuation Purchase Price 20,800 23,700

I r"'oodwill inC I L 2,9oo ____ _..J_

Total Net profit on sale '----------- 5,900--------'

C Ltd paid a price higher than market valuation as a result of the bargaining power of A Ltd.

Fixed Assets Goodwill

Current Assets Stock Debtors Bank

Less Creditors

Net Current liabilities

Ordinary Capital 6% Preference Capital 5% Debentures Debenture Interest Profit and Loss Account

Balance Sheet X Ltd

31,000 24,550

1,950

57,500 72,000

137,000 25,000

(14,500)

£147,500

120,000 25,000 30,000

1,500 (29,000)

£147,500

Y Ltd was formed to take over all the assets. The purchase price was:

(1) 5% Debenture holders accepted £30,000 8% Debentures and two fully paid shares to discharge unpaid interest.

(2) Creditors accepted £2.61 in cash and two £1 fully paid shares for every £4 outstanding.

(3) Preference shareholders received nine fully paid £1 shares for every ten shares in X Ltd. Arrears of preference dividend, £4,500, was paid by the issue of two £1 shares for every £3 of the arrears.

(4) Ordinary shareholders were to receive one share for every three held.


(5) The authorised capital was to be £150,000 in ordinary shares and the remaining shares after the above were to be issued for cash to the public.

(6) Y Ltd valued the Fixed Assets at £100,000, while the current assets were valued at their Balance Sheet figure.

The loss borne by ordinary shareholders can be calculated prior to prepara-tion of the accounts, i.e. Capital 120,000

Shares Accepted 40,000 (1 for 3)

Loss

Working Paper

Purchase consideration calculation

In Y Ltd 8% Debentures

X Ltd 6% Debentures re Interest Creditors Pref. Sl re Dividend Ordinary Shareholders

Authorised Capital

Cash received on issue

Value of Fixed Assets Current Assets

Goodwill

X Ltd Books Realisation

Fixed Assets 13 7,000

Goodwill 25,000 Stock 31 ,000 Debtors 24,550 Bank 1,950

5% Deben-tures 1,500

6% Pref. 500 Creditors 11 ,000

£232,500

y Ltd

Loss to Ordinary Shareholders

30,000

£30,000

----181,500

51,000

£232,500

£80,000

Ord. Shares

3,000 36,000 22,500

3,000 40,000

Cash Total

33,000 4 7,000 83 ,000

25,500 40,000

£104,500 £47,000 181,500

Reali-sation

150,000

£45,500

100,000 57,500

YLtd

157,500

£24,000

Debentures 33,000

181,500 Ordinary shares 25,500

Credi-tors 83,000

Ordinary Shares 40,000

£181,500 £181,500


Ordinary Balance Shares 40,000

Realisa-tion 51,000

P and L a/c 29,000

£120,000

Creditors

y Ltd Cash 4 7,000 Balance Shares 36,000 Realisa-

tion a/c

£83,000

Y Ltd Books X Ltd

8% Deb. 30,000 Fixed Cash 47,000 Assets Ord. Stock Shares 104,500 Debtors

Bank Goodwill

£181,500

120,000

£120,000

72,000

11,000

£83,000

100,000 31,000 24,550

1,950 24,000

£181,500

8% Debentures 30,000


5% Debentures

8% Deben- Balance tures 30,000 b/d 30,000

Ordinary Interest Shares 3,000 b/d 1,500

Realisa-tion 1,500

£33,000 £33,000 =· ---

6% Preference Capital

Ordinary Shares

X Ltd Shares

Balance 25,000 25,500 Reali-

sation 500

£25,500 £25,500 --- ---

Ordinary Shares

X Ltd 104,500 Cash 45,500

Bank

1,950 X Ltd 45,500 Bal

£47,450

47,000 450

£47,450

Balance 450

Balance Sheet Y Ltd

Fixed Assets Goodwill Stock Debtors Cash

Ordinary Shares 8% Debentures

100,000 24,000 31,000 24,550

450

£180,000

150,000 30,000

£180,000


The price to be paid for X Ltd is arrived at by computing the amount each class of the Capital is to receive.

The various interests in X Ltd are prepared to accept the arrangement proposed as they will have the opportunity to participate in future profits and obtain a return which would not have been available before.

The value of the ordinary shares which were issued to the various interested parties varies in accordance with their bargaining powers:

5% Debenture holders value them at 0.50 (3,000 shares for £1,500 interest outstanding)

Creditors value them at 0.75 (36,000 shares for £72,000 - £45,000 cash)

6% Preference shareholders value them at Capital (22,500 shares for £25,000) 0.90 (3,000 shares for £4,500 dividend) 0.66

The creation of goodwill in Y Ltd arises because the assets are valued by Y Ltd at a lower figure than the price it paid for them.

As a result of the reorganisation the company is in an improved financial state. It now has current assets of £56,000 (previously net liabilities £14,500) on which to base its trading prospects. The future profits will have to bear a fixed charge for Debenture Interest £2,400. The remaining profit will be available for ordinary shareholders.

Consolidations

Where there is a group of companies it is often very difficult for a shareholder to know exactly the size and scope of the firm in which he has invested. If he has invested in a holding company the only assets which the firm will have will be investments. The problem is overcome by preparing a set of accounts for the whole group of companies as if it was one business unit. The assets and liabilities of all companies in the group are shown, together with a breakdown of various interests in the firm, e.g. the major and minority shareholdings.

The preparation and use of consolidated accounts will give no further legal rights to the majority shareholders, minority shareholders in the subsidiary companies or the creditors of the individual companies. Each company of the group retains its separate legal identity. No creditor, for example, has the right to claim against the assets of the group other than those of the company to which credit was advanced.

The consolidated Profit and Loss Account will show the results of the group as a whole, excluding profits arising from trading between companies within the group.

When preparing consolidated accounts there are several particular problem areas:

(I) The elimination of capital in one company represented by investments in another.

(2) The division of reserves by the parent company between capital and revenue.


{3) The establishment of minority interests. (4) The elimination of all inter-group indebtedness. (5) The transfer of assets between companies in the group, giving rise to

inter-company indebtedness. {6) Dividends proposed by one company in the group not accounted for by

the recipient companies. {7) The elimination of unrealised profits on inter-group transactions.

The need for consolidated accounts is enforced by the Companies Acts of 1948 (S. 150) and the 1967 Act. Section 154 of the 1948 Act defines a subsidiary company as one which has another company holding more than half its nominal share capital or controlling the composition of the Board of Directors. A holding company is defined (S. 154) as one which has a subsidiary company (Figure 9.1).

A {Holding Company)

I I I I I B c D E F

I j----lL I G H

J K I M

Figure 9.1 A group of companies

Company A is the ultimate parent company but need not be a trading company, having been formed simply fo acquire the shareholdings of other companies. This company will have to prepare the ultimate consolidated accounts for the whole group.

Companies B, C, D, E and F are all subsidiaries of A but may also be parent companies of their own group, as in the case of companies B, C and D. They would consolidate their own group accounts and, in turn, that group would be consolidated by A. Companies G, H, I; J; K and L are subsidiaries of B, C and D, respectively, and are sub-subsidiaries of A as this company controls the composition of the boards of B, C and D, who in turn control the boards of their subsidiaries. Company K would consolidate the accounts of M, their subsidiary. The companies G, H, I; J; K and L are associated companies, since they have no direct connection, as are M, E and F. Associated companies are companies within the same group but not having the same parent companies. The consolidated accounts represent the combined results of a number of companies and not any one specific company, the individual companies maintaining their accounts and passing their results to their holding company who then consolidate with their own results.

The

Cas

e B

alan

ce S

heet

s

A o

wns

100

% o

f th

e sh

ares

in

A

B

Con

soli

date

d B

A

sset

s 20

,000

10

,000

30

,000

T

he c

ost

exac

tly

equa

lled

the

In

vest

mt.

in B

10

,000

. -

the

nom

inal

val

ue i

n B

-c

ost

---

---

---

£30,

000

·· ..

£10,

000

£30,

000

---

··.=

---

Cap

ital

15

,000

"1

0,00

0 15

,000

R

eser

ves

15,0

00

-15

,000

---

---

---

£30,

000

£10,

000

£30,

000

A o

wns

100

% o

f th

e sh

ares

in

B

Ass

ets

20,0

00

5,00

0 25

,000

T

he c

ost

was

gre

ater

tha

n In

vest

men

t in

B

10,0

00.

-th

e no

min

al v

alue

in

B

-co

st

·. C

ost

of

Con

trol

5,0

00

·. £3

0,00

0 ....

..... £

5,00

0 £3

0,00

0 --

---

Cap

ital

15

,000

·.

5,00

0 15

,000

R

eser

ves

15,0

00

-15

,000

£30,

000

£5,0

00

£30,

000

=

Not

es

(a)

The

cos

t of

the

inve

stm

ents

is

set a

gain

st t

he c

apit

al

purc

hase

d (b

) T

he a

sset

s ar

e th

e to

tal

asse

ts

of th

e gr

oup

(c)

The

sha

re c

apit

al w

ill a

lway

s be

tha

t o

f th

e pa

rent

com

pany

(d)

The

cos

t o

f co

ntro

l or

goo

d-w

ill is

cal

cula

ted:

C

ost

of

Inve

stm

t. 10

,000

Le

ss

Cap

ital

Pur

chas

ed

5,00

0 ---

Cos

t o

f C

ontr

ol

£5,0

00

It o

ccur

s w

here

the

cos

t of

ac

quis

itio

n is

grea

ter

than

the

bo

ok v

alue

of

the

capi

tal

acqu

ired

~

~

::r:... 6J $:: ::s ~

..., cs· ::s SJ•

tl:l

$:: "' SJ• ~ t:l ::r:... ,.., 8 $:: ::s ~-

The

Cas

e

A o

wns

100

% o

f th

e sh

ares

in B

T

he c

ost

was

less

tha

n th

e no

min

al

valu

e in

B

A o

wns

i o

f th

e sh

are

in B

T

he c

ost

was

equ

al t

o th

e no

min

al v

alue

Ass

ets

Inve

stm

ent

in B

-c

ost

Cap

ital

R

eser

ves

Ass

ets

Inve

stm

ent

in B

-c

ost

Cap

ital

Res

erve

s

Bal

ance

She

ets

A

B

20,0

00

15,0

00

10,0

00 ...

.... .

£30,

000

··· ...

£1

5,00

0

15,0

00

· .. \5

,00

0

15,0

00

£30,

000

£15,

000

20,0

00

15,0

00

10,0

00 ...

.

£30,

000

···...

£1

5,00

0

15,0

00

····· .

.. 15

,000

15,0

00

£30,

000

£15,

000

Con

soli

date

d 35

,000

£35,

000

15,0

00

15,0

00

Cap

ital

5,

000

Res

erve

£35,

000

Min

orty

In

tere

st

35,0

00

£35,

000

15,0

00

15,0

00

5,00

0

£35,

000

Not

es

(e)

The

cap

ital

res

erve

is c

alcu

late

d:

Cos

t of

Inve

stm

t. 10

,000

C

apit

al P

urch

ased

15

,000

Cap

ital

Res

erve

£(

5,0

00)

It o

ccur

s w

here

the

cos

t of

ac

quis

itio

n is

less

tha

n th

e ca

pita

l acq

uire

d

(j) t

of

the

shar

es in

B a

re o

wne

d by

ou

tsid

e sh

areh

olde

rs.

The

cos

t of

co

ntro

l is

nil

Cos

t o

f sh

ares

L

ess +

cap

ital

+cap

ital

min

orit

y

10,0

00

10,0

00

£5,0

00

The

out

side

sha

reho

lder

s of

B

will

be

know

n as

the

min

orit

y

~

3 1::>

iCi"

I:; ~ 5· ;:s "' 1::> ~ 9 ;:s

C5

..... ~ ~·

;:s "' N 8;

The

Cas

e

A o

wn

s+o

fB a

nd a

t th

e ti

me

of

acqu

isit

ion

the

rese

rves

w

ere

£9,0

00 i

n B

A o

wns

Y, o

f B

and

at

the

date

o

f acq

uisi

tion

the

rese

rves

w

ere£

9,00

0

Ass

ets

Inve

stm

ent

in B

-c

ost

Cap

ital

Res

erve

s

Ass

ets

Inve

stm

ents

in B

-c

ost

Cap

ital

Res

erve

s

A

20,0

00

Bal

ance

She

ets

B

15,0

00

Con

soli

date

d 35

,000

10,0

00...

... --

--

£30,

000

··....

£1

5,00

0 £3

5,00

0

15,0

00

······

.16,

000

15,0

00

15,0

00

9,00

0 15

,000

M

inor

ity

Inte

rest

5 ,

000

£30,

000

A

20,0

00

10,0

00

£30,

000

15,0

00

15,0

00

£30,

000

£15,

000

B

15,0

00

Cos

t of

Con

trol

£15,

000

£35,

000

Con

solid

ated

35

,000

2,50

0

£37,

500

6,00

0 15

,000

9,

000

15,0

00

Min

ority

In

tere

st

7,50

0

£15,

000

£37,

000

Not

es

(g)

The

+ min

orit

y ar

e en

titl

ed

to t

of th

e ca

pita

l and

res

erve

s in

B

+X 6

,000

= 2

,000

-}

x 9,

000

=3,

000

£5,0

00

The

re is

no

cost

of c

ontr

ol

as t

he c

ost

= ca

pita

l and

res

erve

s

tx

6,00

0 =

4,00

0 i-

X

9,00

0 =

6,00

0

£10,

000

Cos

t of

inve

stm

ent

10,0

00

(h)

The

min

orit

y ar

e en

titl

ed

to Y

, of

the

capi

tal a

nd

rese

rves

in B

Y,

X 6

,000

=

3,00

0 Y,

X 9,

000

= 4,

500

£7,5

00

The

cos

t o

f Con

trol

: A

pai

d 10

,000

A

bou

ght Y

, x

6,00

0 =

3,00

0 Y,

X

9,00

0 4,

500

7,50

0

Cos

t of C

ontr

ol

£2,5

00

~ ~

0\ ::t:.. 61 § §- ..... cs· ::s s· ~ s· ~ ::t:.. 8 :;::

: ::s .....

~-

The

Cas

e

A o

wns

t o

f B

and

at

the

date

o

f ac

quis

itio

n th

e re

serv

es

wer

e£6,

000

Ass

ets

Inve

stm

ent

in B

-c

ost

Cap

ital

R

eser

ves

A

20,0

00

10,0

00

£30,

000

15,0

00

15,0

00

£30,

000

Bal

ance

She

ets

B

16,5

00

Cos

t o

f Con

soli

date

d 36

,500

Con

trol

1 ,

000

--

---

£16,

500

(£37

,500

) --

---

--

---

7 ,5

00

15 ,0

00

9,00

0 17

,000

M

inor

ity

Inte

rest

5,

500

£16,

500-

(£37

,500

)

Not

es

The

res

erve

s m

ust

be d

ivid

ed b

etw

een:

pr

e-ac

quis

itio

n an

d po

st-a

cqui

siti

on

Pre

-acq

uisi

tion

pro

fits

are

par

t o

f th

e re

serv

es p

urch

ased

and

are

inc

lude

d in

the

cos

t o

f co

ntro

l or

capi

tal

rese

rve

calc

ulat

ion

Pos

t-ac

quis

itio

n pr

ofit

s ar

e ea

rned

su

bseq

uent

to

purc

hase

and

are

in

com

e

Tot

al

Min

.+

Cos

t o

f R

eser

ves

Cap

ital

7,

500

2,50

0 R

eser

ve

Pre

-Acq

. 6,

000

2,00

0 P

ost-

Acq

. 3,

000

1,00

0

16,5

00

5,50

0

A's

Res

erve

A

's I

nves

t --

£5,5

00

The

min

orit

y in

tere

st is

t o

f to

tal

capi

tal

and

rese

rves

and

in

prac

tice

th

ere

is n

o ne

cess

ity

to u

nder

take

Con

trol

5,

000

4,00

0 -

9,00

0

(10,

000)

(I ,0

00)

the

spli

t o

f th

e re

serv

es.

The

lay

out

show

n sh

ould

pre

vent

err

ors

in t

he

dist

ribu

tion

of

pre-

and

post

-acq

uisi

tion

pr

ofit

s.

2,00

0

2,00

0

15,0

00

17,0

00

~ ~ ~

1::> ~ .... c:;·

;:: "' 1::> s. 9 ;:: ~ ~ .... c:;·

;:: "' t-v

<:::>

'-l

The

Cas

e

A o

wns

100

% o

f th

e sh

ares

in B

T

here

wer

e no

res

erve

s in

Bat

th

e ti

me

of

acqu

isit

ion.

B h

ad

paid

£50

0 to

A b

ut A

had

not

re

cord

ed t

he r

ecei

pt o

f th

e ca

sh,

i.e. c

ash-

in-t

rans

it

Ass

ets

Loa

n to

B

Cur

rent

a/c

B

Inve

stm

ent

in B

-c

ost

L

oan

from

A

Cur

rent

a/c

A

Cap

ital

Res

erve

s

Bal

ance

She

ets

A

15,0

00

3,00

0 2,

000

10,0

00

£30,

000

15,0

00

15,0

00

£30,

000

B

Con

soli

date

d 9,

500

25,0

00

(3,0

00)

(1 ,5

00) Cos

t o

f C

ontr

ol 5

,000

£5,0

00

5,00

0

£5,0

00

£30,

000

15,0

00

15,0

00

£30,

000

Not

es

N

<:::>

Oo

The

loan

s ar

e se

t ag

ains

t ea

ch

:t...

othe

r as

the

y do

not

ref

er t

o 61

outs

ide

liabi

litie

s o

f th

e gr

oup

l::

The

cas

h in

tra

nsit

is a

n as

set

~ o

f th

e gr

oup

and

mus

t be

.... cs· in

corp

orat

ed in

to

the

::s C

onso

lida

ted

Bal

ance

She

et:

s· A

sset

s A

15

,000

b::

l C

ash

in

l:: "'

Tra

nsit

500

s·

--

(1> "'

15,5

00

"' B

9,

500

:t... .... 8

£25,

000

l:: ::s

---

.... C

urre

nt a

/c

~-A

wit

h B

2,

000

Cas

h in

T

rans

it

500

--

1,50

0 B

wit

h A

(1

,500

) -

Cos

t o

f Con

trol

C

ost

of

Inve

stm

ent

10,0

00

Cap

ital

Pu

rcha

sed

5,00

0 --

£5,0

00

The

Cas

e B

alan

ce S

heet

s

A o

wns

100

% o

f th

e sh

ares

in B

A

B

A

t th

e ac

quis

itio

n th

e re

serv

es

wer

e £3

,000

in B

A

sset

s 20

,000

11

,000

In

clud

ed in

the

ass

ets

of

A is

In

vest

men

ts in

st

ock

£4 ,0

00 w

hich

had

bee

n so

ld

B-

cost

10

,000

by

B to

A. T

he s

tock

cos

t B

£3

,000

£3

0,00

0 11

,000

---

--

Cap

ital

15,0

00

7,00

0 R

eser

ves

15,0

00

4,00

0 ---

---

£30,

000

£11,

000

---

---

Con

soli

date

d

30,0

00

£30,

000

15,0

00

15,0

00

---

£30,

000

Not

es

It is

nec

essa

ry t

o el

imin

ate

unre

alis

ed p

rofi

ts o

n in

ter-

grou

p tr

adin

g. T

he s

tock

mus

t be

redu

ced

to t

he v

alue

of c

ost

to

to t

hat g

roup

Sto

ck v

alue

in

A

Sto

ck c

ost

B

Pro

fit

4,00

0 3,

000

£1,0

00

The

ass

ets

and

the

rese

rves

mus

t be

red

uced

Ass

ets

A

B

Les

s Prof

it

20,0

00

11,0

00

31,0

00

1,00

0

£30,

000

Cos

t of C

ontr

ol

Res

erve

s 15

,000

1,

000

16,0

00

1,00

0

£15,

000

Cos

t o

f In

vest

men

t 10

,000

C

apit

al

7 ,0

00

Res

erve

3,

000

10,0

00

Nil

~ ~ ~

l::i ~ c:;·

;::s

"" ~ ~

;::s ~ - ~ .... c:;·

~ ~

The

Cas

e B

alan

ce S

heet

N

otes

N

......

<:::::>

A

ow

ns 1

00%

of

the

shar

es in

B

A

B

Con

soli

date

d T

he p

ropo

sed

divi

dend

mus

t be

A

At

the

tim

e o

f ac

quis

itio

n B

had

A

sset

s 20

,000

20

,000

40

,000

in

clud

ed in

the

Bal

ance

She

et o

f A

, 61

no r

eser

ves

Inve

stm

ent

in B

10

,000

w

hich

wil

l inc

reas

e th

e re

serv

es a

nd

1::

B h

as p

ropo

sed

a di

vide

nd w

hich

Pr

opos

ed D

ivid

end

(4,0

00)

crea

te a

deb

tor.

The

deb

tor

in A

will

~

has

not b

een

incl

uded

in

A's

---

---

---

be s

et a

gain

st t

he p

ropo

sed

divi

dend

ac

coun

ts

£30,

000

£16,

000

£40,

000

cred

itor

in B

.... 6"

C

apit

al

15,0

00

10,0

00

15,0

00

Ass

ets

Res

erve

s ;:

R

eser

ves

15,0

00

6,00

0 25

,000

A

20

,000

15

,000

s·

Div

iden

d t:x:

l £3

0,00

0 £1

6,00

0 £4

0,00

0 du

e 4,

000

4,00

0 1:

: "' B

20

,000

6,

000

s· Pr

opos

ed

~ D

ivid

end

(4,0

00)

-A

---

-.--

(")

£40,

000

£25,

000

8 1::

;: .... ~-

A p

urch

ased

80%

of

B w

hen

its

A

B

Con

soli

date

d A

fter

A a

cqui

red

B th

e in

vest

men

t re

serv

es w

ere

£10,

000

Ass

ets

20,0

00

18,0

00

38,0

00

earn

ed p

rofi

ts b

ut th

e di

vide

nd p

aid

The

nex

t ye

ar i

t m

ade

a In

vest

men

ts in

w

as g

reat

er t

han

the

prof

its

and

was

pr

ofit

2,

000

B-

cost

10

,000

-

part

pai

d ou

t o

f pre

-acq

uisi

tion

C

ost o

f re

serv

es, w

hich

aff

ects

the

cost

of

Paid

a d

ivid

end

(5,0

00)

Con

trol

40

0 co

ntro

l cal

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tion

. The

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ch t

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post

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vest

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ther

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(10,

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00

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) 19

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the

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qual

to

or le

ss t

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post

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furt

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20%

at a

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f £4,

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at

whi

ch t

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the

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15 ,0

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ets

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stm

ents

A

20,0

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date

d (a

) (b

) 48

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48

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re a

re t

wo

way

s to

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te t

he

cost

of

cont

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nd t

he re

serv

es. T

hese

de

pend

on

the

trea

tmen

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the

prof

its

earn

ed f

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the

fir

st a

cqui

siti

on t

o th

e se

cond

acq

uisi

tion

:

£30,

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£28,

000

£48,

000

£48,

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(I)

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ital

15

,000

10

,000

15

,000

15

,000

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eser

ves

15,0

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20,4

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7,00

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5,60

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£48,

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al R

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. In

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t o

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%

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t (6

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) (4

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) A

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00

(6,0

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(1,0

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erve

(7

,000

)

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s

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0

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00

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cula

tion

(II

) is

the

mor

e ac

cura

te a

s th

e fi

rst

acqu

isit

ion

earn

ed p

rofi

t fr

om t

he d

ate

of

acqu

isit

ion,

whi

le t

he s

econ

d ac

quis

itio

n on

ly e

arne

d pr

ofit

s fr

om t

he t

ime

of

its

acqu

isit

ion.

The

min

orit

y in

tere

st f

igur

e w

ill a

lway

s be

the

sam

e, w

hich

ever

met

hod

is u

sed.

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the

date

of

the

seco

nd a

cqui

siti

on t

he r

eser

ves

wer

e £1

5,00

0 -a

n a

ddit

iona

l 20

% h

as b

een

purc

hase

d, t

here

fore

the

pre

-acq

uisi

tion

pro

fit

rela

ting

to t

his

20%

is

£3,

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and

is t

reat

ed a

s a

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A B c

Net Assets 53,000 173,000 664,000

Investment B 240,000

c 252,000

Current a/c B 60,000 (58,000) c 30,000 (30,000)

£635,000 £115,000 £634,000

Ord. Shares 400,000 80,000 270,000

Reserves 125,000 17,000 59,000

Proposed Dividends 30,000 8,000 5,000

8% Debentures 80,000 10,000 300,000

£635,000 £115,000 £634,000

A held stocks bought from Bat £4,000; the stock cost B £3,000. There was £2,000 cash sent from B to A which had not been received by A. A had not anticipated the income from the proposed dividends by B and C. A acquired 90% of B when its reserves were £5 ,000; no dividend had been

proposed or paid other than the one on the present Balance Sheet. A acquired 60% of C when its reserves were £30,000; in the first year it made

profits of £25,000 and paid a dividend of £35,000.


Working Papers

Parent Company B Total Minority I 0% Cost of Control Reserves

Capital 80,000 8,000 72,000 Reserves

Pre 5,000 500 4,500 Post 12,000 1,200 10,800

Proposed Dividend 8,000 800 7,200

£105,000 £10,500 £76,500 £18,000 Cost of Investmts. 240,000

£10,500 £163,500 £18,000 X

c Total Minority 40% Cost of Control Reserves

Capital 270,000 108,000 162,000 Reserves

Pre 30,000 12,000 18,000 Yr. 1 Post 25,000 10,000 15,000 Dividend

Paid (35,000) (14,000) (21 ,000) (6,000) Subsequent

Yrs. 39,000 15,600 23,400 Proposed

Dividend 5,000 2,000 3,000

£334,000 £133,600 £174,000 £26,400 Cost of Investmts. 252,000

£133,600 £78,000 £26,400 y

Reserves of A 125,000 l Unrealised Profit on Stock (1 ,000) z X+Y+Z £144,100 £241,500 £168,400

A Cash from B

B c

Less Unrealised Profit on Stock

Net Assets

Calculation of subsequent years profit for C Balance per Balance Sheet

At acquisition Profits Yr. I

Less Dividend paid

Earned subsequently

Net Assets Cost of Control

Capital Reserves Minority Interest 8% Debentures Proposed Dividends


53,000

2,000 173,000 664,000

892,000

1,000

£891,000

A B c

Debentures

30,000 25,000

55,000 35,000

Balance Sheet A Ltd Consolidated

891,000 241,500

£1,132,500

400,000 168,400 144,100 390,000

30,000

£1,132,500

80,000 10,000

300,000

£390,000

59,000

20,000

£39,000


The following points should be studied:

(1) The shareholders of A would not be aware of the large debenture borrowings by C, nor would they be aware that the total investment of the group is over £1,000,000.

(2) The unrealised profit on the stock has to be eliminated by reducing the reserves and the assets.

(3) The cash in transit must be included in the total assets. ( 4) The loan accounts are set off against each other. (5) Because the Holding Company has not anticipated the receipt of the sub

sidiaries' proposed dividend this increases the holding company's reserves. (6) The dividend payment by C after A had acquired a majority holding was

greater than the post-acquisition profits earned and therefore it reduced the cost of the investment.

(7) If the debentures in a subsidiary were partly held by either the holding company or another subsidiary, the balance owned by outsiders is not included in the minority interest calculation, but is shown as a separate liability. The inter-group indebtedness is eliminated.

Salient features of Statement of Standard Accounting Practice 1

Accounting for Results of Associated Companies

The purpose is to ensure that accounts of investing companies show the manner in which such companies' funds are being employed and the source of the income.

An associated company being defined as one in which some other company (the investing company) holds not less than 20% of the capital, and bearing in mind the distribution of other shareholdings, the investing company is able to exercise considerable influence over the associated company.

Accounting for income

By Investing company

Dividends received - to be taken into account by investing company up to end of its final year.

Dividends receivable - to be taken into account only in so far as they relate to the period covered by the investing company's accounts.

In consolidated accounts

The investing group's share of associated company's profits or losses to be shown. Profit before tax and taxation shown separately. Similarly the investing company's share of retained profit also to be indicated.


EXAMPLE OF PROFIT AND LOSS ACCOUNT FOR A COMPANY WITHOUT SUBSIDIARIES

Profit and Loss Account of an Investing Company Incorporating Results of Associated Companies

Turnover (of the investing company) £X

Operating profit (after charging depreciation and all other trading £ expenses of the investing company) X

Share of profits less losses of associated companies X

Profit before taxation X Taxation: Investing company

Associated companies X X

X

Profit after taxation before extraordinary items X Extraordinary items (investing company and share of associated

companies' items) after taxation X

Profit attributable to members of the investing company comprising: X* Profit of the investing company X Profits retained in associated companies X

Dividends

Net profit retained

By the investing company In associated companies

£X*

X X

£X**

X

£X**


Questions

9.1 Alpha and Beta have been in compeition for a number of years but due to a contraction in the industry they have decided to amalgamate by setting up a company, Alphabet Ltd, to take over all the assets and liabilities of both companies. At the date of takeover the Balance Sheets were as follows:

Alpha Beta Fixed Assets:

Land and Buildings Machinery and Equipment

Current Assets: Stock Dehors Bank

Less Creditors

Capital Accounts

3,250 5,200 1,250

9,700 4,900

6,000 4,000

4,800

£14,800

£14,800

2,200 4,300 1,720

8,220 5,200

The values of the assets to be taken over were agreed as follows: Alpha

Land 12,500 Machinery 2,220 Stock 3,000

1,000 3,500

3,020

£7,520

£7,520

Beta

9,000 1,250 2,400

A provision for bad debts of 10% had to be created for both firms but the other assets and liabilities would remain the same.

The settlement was to be by the issue of ordinary and preference shares in the ratio of Alpha 2:3, Beta 3:2.

You are required to show the profit or loss to each company taken over and prepare the opening Balance Sheet of Alphabet Ltd.

9.2 Low Ltd has been experiencing a period of difficult trading, and it has therefore decided to form a new company, Middle Ltd, to take over its assets.

Balance Sheet of Low Ltd is as follows:

£1 Ordinary Shares £1 3% Preference Shares 5% Debentures Retained Profits Current Liabilities

300,000 30,000 50,000

120,000

£500,000

Fixed Assets Current Assets P and L a/c

390,000 30,000 80,000

£500,000


Terms of the reconstruction were as follows:

Middle Ltd to have an authorised capital of £1.Sm. in ordinary shares of £1 and to issue 7% debentures to cover amount required for issue to Low Ltd.

Purchase consideration was calculated as follows:

5% Debenture holders accepted £25,000 7% debentures in Middle Ltd and 10 £1 ordinary shares for every £10 of debentures in Low Ltd. 3% Preference shareholders accepted 5 £1 ordinary shares in Middle Ltd for every 6 preference shares held in Low Ltd. Ordinary shareholders accepted 1 ordinary share in Middle Ltd for every 3 shares in Low Ltd. Creditors accepted 2 ordinary shares in Middle Ltd for every £4 due by Low Ltd and £80,000 in cash.

Middle Ltd valued the fixed assets of Low Ltd at £340,000.

You are required to prepare the accounts in respect of the above transactions in the books of Low Ltd, and the Balance Sheet of Middle Ltd on the completion of all the above transactions.

9.3 The summarised Balance Sheet of Stalemate Ltd on 30 June was as follows:

Issued share capital: 150 ,000 Ordinary shares of£1 each 60,000 6% Cumulative preference share of £1 each

5% Debentures Trade Creditors

Balance Sheet

150,000

60,000 40,000 80,000

£330,000

Goodwill Freehold properties Plant and machinery Stock in trade Debtors Profit and Loss a/c Bank

Note: Preference dividend is 5 years in arrears.

24,000 72,000

109,000 23,000 31,000 52,000 19,000

£330,000

The following scheme of reconstruction has been accepted by all concerned.

A new company was formed to take over all the assets of Stalemate. The authorised capital of the company is 200,000 ordinary shares of £1 each.


Purchase consideration was calculated on the following basis: (i) The holders of the 5% debentures accepted, in settlement of their claim,

an allotment, at par, by the new company, of 300 8% debentures of £100 each and 12,000 shares of £1 each.

(ii) The preference shareholders received an allotment, at par, of four ordinary shares in the new company for every five preference shares in the old company, and, in addition, one ordinary share in the new company for every £3 of arrears of preference dividend.

(iii) The trade creditors of the old company accepted, in full settlement, an allotment, at par, by the new company, of 280 8% debentures of £100 each and £50,000 in cash.

(iv) The ordinary shareholders of the old company received an allotment, at par, of one share in the new company for every two shares in the old company.

(v) The plant and machinery was valued at £86,000. The stock in trade, debtors and balance at bank were taken over at the amounts shown in the Balance Sheet of the old company. The balance of the purchase consideration is to be taken as the value of the freehold properties.

(vi) The remainder of the authorised capital of the new company was issued to the public, at par, for cash and fully paid up.

Close the books of Stalemate Ltd and show the Balance Sheet of the new company.

9.4 From the following Balance Sheets you are required to prepare a consolidated Balance Sheet of H. Co. and its two subsidiaries. There are no inter-com· pany balances and the investments by H. and S. were made at the same date. There are no pre-acquisition profits or reserves.

Capital Pand La/c Creditors Reserve

Capital Reserve P and La/c Bills Payable

H.Co.

100,000 Investment in 60,000 S. 9,000 Co. Shares at cost

10,000 Investment in 10,000 S.S. 7,000 Co. Shares at cost

Bills Receivable Stock -in -trade Fixed Assets Current Assets

£126,000

S. Co.

75,000 Investment in 30,000 S.S. 8,000 Co. Shares at cost 4,000 Fixed Assets 5,000 Current Assets

£92,000

70,000

12,000 1,000

10,000 43,000 10,000

£126,000

36,000 40,000 16,000

£92,000

Capital Reserve P and La/c


S.S. Co.

50,000 Fixed Assets 5,000 Current Assets 4,000

£59,000

39,000 20,000

£59,000

9.5 The following are the Balance Sheets of Large Ltd and its subsidiary Small Ltd. You are required to prepare a consolidated Balance Sheet.

Large Ltd

Share Capital - 50,000 Investment in Small Ltd at Shares of £1 each 50,000 cost - 30 ,000 shares 42,000

5% Debentures 20,000 Fixed Assets 20,000

Sundry Creditors 10,000 Sundry Debtors General Reserve 5,000 Small Ltd 2,000 P and L a/c 8,000 Others 17,000

19,000 Bills Receivable 3,000 Stock-in-trade 8,000 Cash at Bank 1,000

£93,000 £93,000

Small Ltd

Share Capital -40,000 Fixed Assets 38,000 Shares of £1 each 40,000 Sundry Debtors 11,000

Stock-in-trade 12,000 Sundry Creditors 6,000 Cash at Bank 3,000

Bills Payable to L. Ltd 7,000 General Reserve 5,000 P and L a/c 6,000

£64,000 £64,000

Large Ltd purchased the shares of Small Ltd at a time when the General Reserve and Profit and Loss Accounts stood at £4,000 and £2,400, respectively.

The stock-in-trade held by Large Ltd includes stock purchased from Small Ltd for £3,000, Small Ltd having made a profit thereon of20 per cent.


9.6 Summarised Balance Sheets of Grey Ltd, Black Ltd and White Ltd at 31 December are shown below:

Issued Share Capital (£1 ordinary shares) Revenue Reserves at 31 December 6% Debenture Stock Loan from Grey Proposed Dividends Current liabilities

Fixed Assets 60,000 shares in Black Ltd at cost 80,000 shares in White Ltd at cost Loan to Black Ltd Current Assets

Grey Ltd

50,000

39,700

40,000

10,000 15,300

£155,000

38,000 80,000

14,000 23,000

£155,000

Black Ltd

60,000

35,600

85,000 14,000 10,000 36,400

£241,000

90,000

125,000

26,000

£241,000

White Ltd

100,000

28,000

90,000

12,500 151,500

£382,000

184,000

198,000

£382,000

Grey Ltd acquired its shares in Black Ltd when the revenue reserves of Black Ltd were £28,000 and Black Ltd acquired its shares in White Ltd when the revenue reserves of White Ltd were £44,000. At the time of acquisition no dividends were proposed, and no changes have occurred in the issued share capital of either subsidiary since acquisition.

The proposed dividends for each company at 31 December have been deducted in the calculation of revenue reserves for the relevant company, but the dividends have not been anticipated in the accounts of the recipient companies.

All debenture stock is held by owners outside the group. Debenture interest for the year has been deducted in the calculation of profits, and accrued debenture interest has been included in current liabilities as appropriate.

Included in the current assets of Black Ltd at 31 December were goods which were purchased from Grey Ltd for £3,000. These goods had cost Grey Ltd £2,520.

Required: The consolidated balance sheet of the group at 31 December.


9.7 The summarised Balance Sheets of Sky Ltd, doud Ltd and Moon Ltd at 31 December 19-1 were:

Sky Ltd Cloud Ltd Moon Ltd

Fixed Assets Freehold property 23,000 68,000 53,000 Equipment Less depn. 8,000 60,000 36,000

Investments 120,000 Current Assets 28,000 57,000 60,000 Current a/cs

Moon 20,000 Cloud 25,000

73,000 57,000 60,000 Less Liabilities 25,000 10,300 31,500 Current a/c Sky

48,000 22,000 20,000

24,700 8,500

£199,000 £152,700 £97,500

Share Capital (£ Ords) 120,000 60,000 50,000 P. and La/c 79,000 32,700 47,500 6% Redeemable

Debentures 60,000

£199,000 £152,700 £97,500

An analysis showed:

Investments: 40,000 shares in doud Ltd cost £70,000 and at the date of acquisition the Profit and Loss Account was £25,000; 40,000 shares in Moon Ltd cost £50,000 and at the date of acquisition the Profit and Loss Account of Moon was £40,000.

Dividends: The subsidiary companies had not paid any dividends since they were acquired.

Current Accounts: Sky Ltd has sent a cheque for £3,000 to Cloud Ltd which was not received and entered in the books until January 10 19-2; Moon Ltd had sold goods to Sky Ltd which cost £6,000 for £12,000. 25% of the goods were still held in stock by Sky Ltd at 31 December 19-1

Required: A consolidated Balance Sheet at 31 December 19-1 for the group {all calculations should be submitted).

CHAPTER 10

Budgetary Control

Financial accounting is concerned with the recording of monetary transactions after the event, and the results have then been translated via the Income Statement showing the effect of such transactions in the form of profit or loss.

Management, however, may wish to know the effect of a variety of transactions prior to the event and as an aid to this process will require the preparation of budgets by as many departmental heads as is considered necessary.

A budget is defined as 'an attempt to estimate future income and expenditure on the basis of past events after allowing for expansion and rising costs'. It is a statement of management policy, setting a standard to compare with actual results.

Assume a company has sold 1 ,000 products at £2 each, the cost of which are materials 75p, labour 40p, overheads 15p. The results for the trading period would be:

Sales Materials Labour Overheads

Profit

1,000 @ £2 1,000 @ 75p 1,000 @ 40p 1,000 @ 15p

750 400 150

2,000

1,300

£700

If management considered that it was possible to increase Sales by 50% they would require to know the effect of the expansion in terms of additional cost. A budget would be prepared as follows:

Anticipated revenue: Sales

Anticipated costs: Material Labour Overheads

Anticipated profit

1,500 @ £2

1,500 @ 75p 1,500 @ 40p 1,500 @ 15p

1,125 600 225

3,000

1,950

£1,050

Budgetary Control 225

As a result of the preparation of budgets management can determine the funds required to meet future programmes and the manner in which funds can be raised.

In practice the preparation of budgets commences some months prior to the beginning of a financial year and involves the consideration of the results for the last full financial year, the results to date, say the half-year position of the current financial year compared with the anticipated results, and any future trends in costs and selling prices. The preparation of budgets involves considerable co-ordination between a number of departments, e.g. sales manager, production manager, purchasing manager. The sales department may have markets but the production manager has neither the capacity nor the labour force to meet such targets - the purchasing manager may have difficulty in obtaining supplies in the required quantities. The board of directors may not consider it possible to raise the necessary funds to meet expansion. Government policy may inhibit capital investment.

The inception of a budget policy will require the setting up of a programme and an understanding of the many problems involved.

Necessity for Budgetary Control

(1) Growth of business requires greater control over activities - owner must delegate authority but requires targets for control purposes.

(2) Increased variety in products requires control of facilities. (3) Need to ensure there is adequate labour force and it is fully utilised. (4) Need to control expenditure on research and development and cost of

research into new markets. (5) Need to control activities of departmental managers. (6) Ensure that all expenditure is allocated to defmable sections of the

organisation and managers aware of their responsibilities. Budgetary control might be defined as a system of controlling costs,

co-ordinating departments, defining resp<Omsibility and comparing actual results with budgeted targets and taking necessary corrective action.

The results of budgetary control are the combining of ideas, delegation of authority, management decision-making, the directing of capital expenditure to the most profitable projects.

The setting up of a budgetary control system will require: (a) the creation of cost centres to which expenditure can be charged; (b) preparation of organisation chart fixing responsibility; (c) compilation of a budget manual; (d) the establishment of a budget committee to co-ordinate departmental budgets and agree targets.

The budget committee consists of a body of executives charged with responsibility for fmal targets and might include: directors, company secretary, company accountant, works manager, sales manager, purchasing manager, chief engineer, design manager.

The purpose of the committee is to (i) issue instructions by means of budget manual; (ii) provide background information e.g. board decision affecting future planning; (iii) agree on adjustments to departmental budgets; (iv) take account of key factors; (v) approve the master budget.


Budget Manual

This gives the rules regarding preparation of individual budgets. It will provide: (1) Description of system (including document flow chart). (2) Responsibility of individuals and departments for completion of forms. (3) Method of completing forms. (4) Code numbers of all forms and accounts. (5) Deadlines for completion of budgets and periodic statements explaining variances. Key Factors

Key factors are those which must be assessed to ensure that the budget can be met, and might include: (a) material, labour availability and quantity; (b) capital requirements; (c) delivery dates of new plant; (d) possibility of obtaining additional space; (e) market changes; (/) research necessary for developing new product and/or market; (g) productive capacity; (h) demand for product at given price levels; (i) government policy, i.e. taxation and licensing.

The budget committee will be faced with the problem that either demand exceeds capacity or capacity exceeds demand, and the following factors will require investigation: (i) research into substitutes or acquisition of sources of supply; (ii) training programmes, work study, new machines, etc., to improve or overcome labour deficiences; (iii) introduction of shift working to overcome production bottlenecks or placing of work with outside suppliers; (iv) consideration of alternatives of additional advertising or price reduction to increase proportion of market.

Sales Budget The system of budget preparation must follow a logical pattern, commencing

with the results of market research and leading to preparation of the sales budget. In examination questions it will often be necessary to calculate sales by means of cost information, profit margin and anticipated revenue.

Example Material X- 3 lb.@ £3 Material Y- 3 lb.@ £1 Labour- 7 hrs.@ £1 per hr.; 27furs.@ 80p per hr. Overheads- 33!% of direct labour Profit margin - 20% of selling price Sales revenue - £4,200,000

Calculations are: Cost Material X 3 lb. @ £3 y 3lb.@ £1

Labour 7 hrs. @ £1 2~hrs.@ 80p

Overheads 33! % of direct labour

Profit @ 20% of selling price = 25% of cost

Selling price

9 3

12 7 2

9 3

24

6 £30


Revenue required = £4,200,000

Selling price per unit 30 :. Sales 140,000 units

The sales budgets, in addition to showing revenue by products, will also indicate sales by division, region and individual salesmen. Information has been obtained from market research, salesmen's reports, past sales and effects of government and company policy.

Key factor: may well be selling price.

Production Budget

An indication of requirements to meet the sales target will take into account production to maintain stock levels and effect of existing stocks:

Sales, as above Add closing stock (say)

Less opening stock (say)

Required

140,000 25,000

165,000 20,000

145,000

The production manager is now in a position to calculate labour requirements and availability and will use the information for the preparation of labour utilisation budgets, bearing in mind the size of the labour force and the time loss through holidays, sickness and strikes, etc.

The production budget, in conjunction with the labour utilisation budget, will enable decisions to be reached as to the necessity for overtime working, subcontracting, plant purchases, price reductions, advertising increase or production changes to overcome the variance between capacity and requirements.

Labour utilisation Grade A

Hours per unit 7 Production 145,000 Total hours 1,015,000 Cost@ £1 £1,015,000

Present labour force 600 Working year - 5 days x 8 hrs. x 50 wks. =

Grade B 2;2 145,000 362,500

@SOp£290,000 = £1,305,000 180

2,000 hrs. Less Statutory holidays 2 wks.

Sickness 1 wk. Idle time 1 wk.

4 wks. x 40 hrs. 160

Hours available- 600 x 1,840 Budget requirements

Surplus hrs. Staff equivalent not utilised Capacity

1,104,000 1,015,000

89,000 48

92%

1,840 hrs 180 X 1,84Q--n1,2QQ

362,500

Shortfall Staff required

31,300 17

110%


The labour utilisation budget is an indication of the need to train Grade B personnel in order to overcome shortages. Management also has to come to a decision concerning the surplus Grade A labour: is it possible to obtain work or must they be declared redundant?

A similar budget will be prepared in respect of machine hours, indicating either the necessity to purchase additional machines or hire out surplus machine time.

Key factors: labour - the type of labour available; machines - capital required for new purchases.

Material usage and purchases

Based on production levels and allowing for stocks of raw materials:

Material X y Production 145,000 units 3lb. 3lb.

usage 435,000 435,000 Add Closing Stock 22,000 15,000 (say)

457,000 450,000 Less Opening Stock 38,000 25,000

(say)

Purchases 419,000 425,000

@£3 @£1 £1,257,000 £425,000 £1,682,000

Key factor: may be supplier's ability to maintain delivery dates.

Expenses Budgets

Each department will prepare details of anticipated expenditure by classification. Factory overheads will include the cost of indirect material, indirect labour, management costs, factory rent, rates, light, heat, power, plant depreciation and warehousing.

Office overheads will include costs of office salaries, welfare and personnel, office rent and rates, light and heat and equipment depreciation.

Selling and distribution overheads will include sales salaries, advertising, entertaining, transport costs (including vehicle depreciation).

Subdivision may require details of types of advertsing; for example, television, press, radio.

Research and development overheads will include costs of the drawing office, engineers' or chemists' salaries, with a breakdown of potential costs by project.

Administration overheads include costs of the directorate where these cannot be allocated to particular sections, consultancy fees, conferences, and the costs of raising funds, e.g. interest charges, legal and bank charges.

The expenditure budgets will form the basis for the cash budget showing anticipated receipts and payments.


All budgets mentioned so far will be prepared on an annual basis, the funds requested being available only for the respective financial year as there is no carry forward of unspent balances. The budgets are not an indication of maximum expenditure but levels allowed on the basis of production and sales, any changes in these affecting expenditure levels.

In addition the information should be provided on a monthly or other basis, e.g. seasonal, in order that actual results may be compared with targets as quickly as possible so that remedial action can be taken.

Capital Expenditure Budget

This gives an indication of the projects to be undertaken on a long-term basis, say up to five years, and on which annual approval will be necessary, the unspent amounts being carried forward until the project is completed. In times of inflation it will be necessary to review the unspent portions to ascertain the increase in funds necessary to complete purchase.

The capital expenditure budget will form a basis for management decisions as to the type of finance to be used and the manner in which it is to be raised.

Key factor: may well be the state of the money market, e.g. prospects and costs of raising funds.

Cash Budget

This will indicate receipts by type, e.g. sales revenue, investment income, plant disposal proceeds and payments in accordance with various expenditure budgets.

It will give an indication of available balance or funds required on at least a monthly basis and gives due notice as to action required, e.g. short-term overdraft or loan or long-term capital.

Key factor: likely to be the rate of inflow of funds.

Based on anticipated production, expenditure will be £435,000 (145,000 units@ £3) and departmental budgets would appear as:

Factory Research Office Admin. Selling Total Indirect

Materials 80,000 20,000 100,000 Indirect

Labour 30,000 30,000 Mgt. Salaries 15,000 5,000 3,000 12,000 20,000 55,000 Supervisory 14,000 14,000

Salaries Office and Admin.

Expenses 2,000 4,000 7,000 3,000 10,000 26,000 Legal Costs and

Interest 7,000 4,000 8,000 19,000 Insurance 10,000 8,000 5,000 12,000 15,000 50,000 Depreciation 80,000 10,000 6,000 3,000 42,000 141,000

£231,000 £54,000 £25,000 £38,000 £87,000 £435,000


Receipts - Sales

Payments - Materials Labour Indirect Material Indirect Labour Salaries General Expenses Legal Costs Insurance

Balance

Cash Budget

Total £4,200,000

1,682,000 1,305,000

100,000 30,000 69,000 26,000 19,000 50,000

3,281,000 919,000

£4,200,000

Monthly Details

Allowance should be made for the length of credit taken and given by customers and creditors and the fact that some payments are made at fixed times in the year.

The monthly cash budget would also indicate the balance brought forward at the commencement of each period.

Master Budget

This is the amalgamation of all budgets with the exception of capital budgets, in the form of an Income Statement and Balance Sheet, giving an indication of percentage return on sales, revenue expenses as a percentage of revenue, state of working capital, changes in fixed assets.

Key factor: may well be the expected return on capital employed.

Master Budget (Income Statement)

Revenue- 140,000 units@ £30 Expenditure

Profit

Material - 140,000 @ £12 Labour- 140,000@ £9 Factory Overheads Research Office Overheads Admin. Overheads Selling Overheads

Would be detailed by type of expenditure

£4,200,000

1,680,000 1,260,000

231,000 54,000 25,000 38,000 87,000

3,375,000 825,000

% 100

40 30

5.5 1.3 0.6 0.9 2.1

80.4 19.6

£4,200,000 100.0

The material and labour costs incurred in production of the additional 5 ,000 units will be shown on the Balance Sheet as stock.


The total costs and percentage return will be compared with previous years' results after allowing for changes in sales, production levels and effects of inflation. Management will be able to make forecasts as to anticipated interim and final dividends.

From the information provided the following budgets will be prepared on a quarterly and annual basis:

Sales Production Material Usage and Purchases Labour Utilisation Machine Utilisation Expenses Cash Profit and Loss Balance Sheet

The Balance Sheet at 1 January was:

Leaseholds Plant Fittings Vehicles

Current Assets Stocks: Finished Goods

Raw Materials Debtors Bank

Current liabilities Creditors Taxation Proposed Dividend

Ordinary Shares of £1 Retained profits 8% Debentures

Units and Revenue Units Quantities and Costs Hours and costs Hours Costs Receipts and payments

Cost Depre-ciation

450,000 90,000 320,000 125,000

86,000 54,000 25,000 15,000

Net

360,01)0 195,000 32,000 10,000

£881,000 £284,000 £597,000

304,000 330,000

50,000 130,000

814,000

80,000 130,000 58,000 268,000

546,000

£1,143,000

580,000 313,000 250,000

£1,143,000


Expenditure budgets for the year have been prepared as follows:

Payable Factory Admin. Selling Total

Rent and Rates Qtrly. 44,000 26,000 14,000 84,000 Ught and Heat " 59,000 14,800 11,800 85,600 Transport Monthly 6,200 6,200 Insurance Annual 58,800 6,400 2,700 67,900 Repairs Monthly 51,600 400 1,000 53,000 Commission Qtrly. 25,200 25,200 Salaries Monthly 112,100 31,600 55,000 198,700 Loan Interest Qtrly. 20,000 20,000 Advertising Monthly 90,000 90,000 Depreciation:

Lease 2% 7,000 1,000 1,000 9,000 Plant 10% 37,600 37,600 Fittings 7~% 3,900 1,800 2,300 8,000 Transport 20% 7,000 7,000

£374,000 102,000 216,200 692,200

Capital expenditure approved:

Plant - £50,000 1st Quarter Fittings- £20,000 2nd Quarter Vehicles- £10,000 3rd Quarter

The proposed dividend and taxation outstanding at 1 January will be paid in the first quarter. The tax on the dividend will be paid in the second quarter.

An interim dividend of £29,000 will be paid in the third quarter. A final dividend of 15% will be proposed. Taxation will be estimated at

£42,000. Seventy-five per cent of sales are for cash; remaining debtors pay two months

after sale. Creditors are paid one month after delivery.

Stocks

Finished Goods Opening Closing

Materials Opening dosing

Product

A B £40 £28

2,000 units 8,000 units 4,000 16,000

Component X y £8 £5

10,000 units 50,000 units 6,000 10,000


Sales for the year are budgeted as follows:

Product: A Selling Price £60 B £45

1st. Quarter 2nd. Quarter 3rd. Quarter 4th Quarter

Material specification:

Component Cost

Product A Product B

labour specification:

Grade Rate

Product A Product B Machine time

Department Product A Product B

6,000 units 7,000 units 2,000 units 6,000 units

1

X £8 3 1

£2 per hr. 2 hrs. 1 hr.

A ~hr. ~hr.

2

10,000 units 8,000 units 6,000 units 4,000 units

y £5 2 3

£1 per hr. 2 hrs. 3 hrs.

B 1 hr. 1 hr.

The factory operates an 8 hr. 5-day week for 50 weeks. 2 hrs. per week is considered idle time and 12 days per employee for statutory holidays, sickness, etc. 10% of machine time is allowed for maintenance.

Sales Budget

Product A Units Value B Units Value Total (£60) (£45) revenue

1st qtr. 6,000 360,000 10,000 450,000 810,000 2nd qtr. 7,000 420,000 8,000 360,000 780,000 3rd qtr. 2,000 120,000 6,000 270,000 390,000 4th qtr. 6,000 360,000 4,000 180,000 540,000

21,000 £1,260,000 28,000 £1,260,000 £2,520,000

Cash sales Credit sales

(75%) (25%) 1st qtr. 607,500 202,500 2nd qtr. 585,000 195,000 3rd qtr. 292,500 97,500 4th qtr. 405,000 135,000

£1,890,000 £630,000 £2,520,000


Cash sale receipts received in quarter. Credit sale receipts: 1 month relating to quarter, 2 months arrears from

previous quarter.

Production Statement

Total lstqtr. 2nd qtr. 3rd qtr. 4th qtr.

Product A Sales 21,000 6,000 7,000 2,000 6,000

Add Closing Stock 4,000 1,000 2,000 3,000 4,000

25,000 7,000 9,000 5,000 10,000 Less

Opening Stock 2,000 2,000 1,000 2,000 3,000

Production required 23,000 5,000 8,000 3,000 7,000

--- -- -- -- --Product B

Sales 28,000 10,000 8,000 6,000 4,000 Add

Closing Stcok 16,000 4,000 8,000 12,000 16,000

44,000 14,000 16,000 18,000 20,000 Less

Opening Stock 8,000 8,000 4,000 8,000 12,000

Production required 36,000 6,000 12,000 10,000 8,000

--For the purpose of illustration stocks have been assumed to move evenly

during the year.

Material Usage and Purchasing Budget

Component X y Total Cost Annual

Product A 23,000 69,000 46,000 B 36,000 36,000 108,000

Total Usage 105,000 154,000 Add Closing Stock 6,000 10,000

111,000 164,000 Less Opening Stock 10,000 50,000

Total Purchases 101,000 114,000 @£8 @£5

£808,000 £570,000 £1,378,000

Mat

eria

l Pur

chas

ing

Per

iod

1st Q

tr.

2nd

Qtr

. Jr

d Q

tr.

4th

Qtr

.

Com

pone

nt

X

y X

y

X

y X

y

A 3

X 5

,000

15

,000

10

,000

8,

000

24,0

00

16,0

00

3,00

0 9,

000

6,00

0 7,

000

21,0

00

14,0

00

2Y

B I

X 6

,000

6,

000

18,0

00

12,0

00

12,0

00

36,0

00

10,0

00

10,0

00

30,0

00

8,00

0 8,

000

24,0

00

3Y

21,0

00

28,0

00

36,0

00

52,0

00

19,0

00

36,0

00

29,0

00

38,0

00

Add

Clo

sing

S

tock

1,

500

2,50

0 3,

000

5,00

0 4,

500

7,50

0 6,

000

10,0

00

22,5

00

30,5

00

39,0

00

57,0

00

23,5

00

43,5

00

35,0

00

48,0

00

Les

s O

peni

ng

Sto

ck

10,0

00

50,0

00

1,50

0 2,

500

3,00

0 5,

000

4,50

0 7,

500

Qua

ntit

y 12

,500

(1

9,50

0)

37,5

00

54,5

00

20,5

00

38,5

00

30,5

00

40,5

00

Purc

hase

d -1

9,5

00

35,0

00

Cos

t £

8

£5

£100

,000

30

0,00

0 17

5,00

0 16

4,00

0 19

2,50

0 24

4,00

0 20

2,50

0

Qua

rter

ly

Tot

als

£100

,000

£4

75,0

00

£356

,500

£4

46,5

00

£1,3

78,0

00

For

the

purp

ose

of t

he e

xam

ple,

clo

sing

sto

ck is

ass

umed

to

mov

e ev

enly

thr

ough

out

the

year

. t:l::

l

Paym

ents

in e

ach

quar

ter:

one

mon

th a

rrea

rs, t

wo

mon

ths

curr

ent

quar

ter.

~ <I>

Lab

our

Cos

t Bud

get

E'

~

Tota

l 1s

t Qtr

. 2n

d Q

tr.

Jrd

Qtr

. 4t

h Q

tr.

g H

rs.

Cos

t H

rs.

Cos

t H

rs.

Cos

t H

rs.

Cos

t H

rs.

Cos

t ~ .... C:1

Gra

del

@£2

82

,000

16

4,00

0 16

,000

32

,000

28

,000

56

,000

16

,000

32

,000

22

,000

44

,000

-

2@

£1

15

4,00

0 15

4,00

0 28

,000

28

,000

52

,000

52

,000

36

,000

36

,000

38

,000

38

,000

t-

v ~

236,

000

£318

,000

44

,000

£6

0,00

0 80

,000

£1

08,0

00

52,0

00

£68,

000

60,0

00

£82,

000


Labour availability budget

Grade 1 2

Weekly hours: 5 days @ 8 hrs. 40 hrs. Weeks in year 50 Annual hours per employee 2000 Employees: Grade A 40

Grade B 80 Total annual hours by grade 80,000 160,000 Less hours not available:

2 hrs. per week per employee Idle time (50 weeks) 100 4,000 8,000

12 days per year per employee Sick etc (8 hrs.) 96 hrs x 40 Staff 3,840 7,840

x 80 Staff 7,680 15,680

Hours actually available 72,160 144,320 --- ---

Per quarter 18,040 36,080 ---

Hours required Units 1st Qtr. Product A 5000 10,000 10,000

B 6000 6,000 18,000

16,000 28,000 2nd Qtr. A 8000 16,000 16,000

B 12000 12,000 36,000

28,000 52,000 3rd Qtr. A 3000 6,000 6,000

B 10000 10,000 30,000

16,000 36,000 4th Qtr. A 7000 14,000 14,000

B 8000 8,000 24,000

22,000 38,000

Total 82,000 154,000 --- ---

This budget indicates that although available hours are exceeded in total it is only in the second quarter that the position is acute. The company will have to consider subcontracting the work and/or obtaining part-time staff. The shortfall in the 4th quarter could be overcome by overtime working to the extent of 2 hours per day grade A and ~hour per day grade B.

Machine availability budget

Department

Weekly hours: 5 days@ 8 hrs. 40 Weeks 50 Annual hours per machine 2000 Machines

Total annual hours Less 10% Maintenance

Hours available

per quarter Hours required

Units 1st Qtr. Product A 5,000

B 6,000

2nd Qti. Product A 8,000 B 12,000

3rd Qtr. Product A 3,000 B 10,000

4th Qtr. Product A 7,000 B 8,000

A

10 20,000

2,000 --18,000

4,500

2,500 3,000

5,500 4,000 6,000

10,000 1,500 5,000

6,500 3,500 4,000

7,500

29,500 --


5,000 6,000

8,000 12,000

3,000 10,000

7,000 8,000

B

36 72,000

7,200

64,800

16,200

11,000

20,000

13,000

15,000

59,000

The machine utilisation statement indicates the necessity for additional machines in department A as from the commencement of the year. The application is included in the capital expenditure budget. Due to the seasonal requirements management decision will be necessary as to minimum number of machines to be purchased and the extent to which machines will be hired in the second quarter. With regard to under-utilisation in department B, management will have to consider the possibility of hiring out or disposing of surplus machines and the need to purchase or hire machines in the second quarter.

Ove

rhea

d E

xpen

ditu

re B

udge

ts

N ~

Fac

tory

To

tal

1st Q

tr.

2nd

Qtr

. 3r

dQtr

. 4t

h Q

tr.

Not

es

A

Ren

t an

d R

ates

44

,000

11

,000

11

,000

11

,000

11

,000

~

Lig

ht a

nd H

eat

59,0

00

11,0

00

20,0

00

13,0

00

15,0

00

(A)

I:

;:s

Insu

ranc

e 58

,800

14

,700

14

,700

14

,700

14

,700

~

Rep

airs

51

,600

12

,900

12

,900

12

,900

12

,900

....

Sala

ries

11

2,10

0 20

,900

38

,000

24

,700

28

,500

(B

) cs· ;:s

D

epn.

-·

Lea

se

7,00

0 1,

750

1,75

0 1,

750

1,75

0 ;:s

t::o

Pla

nt

37,6

00

9,40

0 9,

400

9,40

0 9,

400

I: ""

Fit

ting

s 3,

900

975

975

975

975

s· (I>

374,

000

82,6

25

108,

725

88,4

25

94,2

25

"" "" A A

dmin

. To

tal

1st Q

tr.

2nd

Qtr.

3r

d Q

tr.

4th

Qtr

. N

otes

<"

I 8 R

ent

and

Rat

es

26,0

00

6,50

0 6,

500

6,50

0 6,

500

I:

;:s

Lig

ht a

nd H

eat

14,8

00

5,50

0 1,

850

1,85

0 5,

600

(A)

.... In

sura

nce

6,40

0 1,

600

1,60

0 1,

600

1,60

0 ~-

Rep

airs

40

0 40

0 Sa

lari

es

31,6

00

5,80

0 12

,000

6,

900

6,90

0 (B

) In

tere

st

20,0

00

5,00

0 5,

000

5,00

0 5,

000

Dep

n.

Lea

se

1,00

0 25

0 25

0 25

0 25

0 F

itti

ngs

1,80

0 45

0 45

0 45

0 45

0 10

2,00

0 25

,100

28

,050

22

,550

26

,300

Fac

tory

37

4,00

0 A

dmin

. 10

2,00

0 Se

lling

21

6,20

0

£692

,200

Selli

ng

Tota

l 1s

t Qtr

. 2n

d Q

tr.

3rd

Qtr

. 4t

h Q

tr

Not

es

Ren

t an

d R

ates

14

,000

3,

500

3,50

0 3,

500

3,50

0 L

ight

and

Hea

t 11

,800

3,

800

1,50

0 1,

500

5,00

0 (A

) T

rans

port

6,

200

2,00

0 2,

000

1,10

0 1,

100

(D)

Insu

ranc

e 2,

700

675

675

675

675

Rep

airs

1,

000

1,00

0 (C

) C

omm

issi

on

25,2

00

8,10

0 7,

800

3,90

0 5,

400

(E)

Sala

ries

55

,000

13

,750

13

,750

13

,750

13

,750

A

dver

tisin

g 90

,000

30

,000

15

,000

20

,000

25

,000

(F

) D

epn.

L

ease

1,

000

250

250

250

250

Fit

ting

s 2,

300

600

600

600

500

Tra

nspo

rt

7,00

0 1,

750

1,75

0 1,

750

1,75

0

£216

,200

64

,425

47

,825

47

,025

56

,925

Not

es:

(A)

Lig

ht a

nd H

eat:

Fac

tory

, app

orti

oned

in r

elat

ion

to p

rodu

ctio

n. A

dmin

. and

Sel

ling,

on

vari

able

qua

rter

ly b

asis

. (B

) Sa

lari

es:

Fac

tory

, on

bas

is o

f pr

oduc

tion

giv

ing

rise

to a

ddit

iona

l st

aff

or o

vert

ime.

Adm

in,

on b

asis

tha

t pa

rt-t

ime

staf

f w

ill b

e ne

eded

. (C

) R

epai

rs:

char

ged

to s

econ

d qu

arte

r in

vie

w o

f min

or a

mou

nt in

volv

ed.

(D)

Tra

nspo

rt:

appo

rtio

ned

on b

asis

of s

ales

; inc

reas

e in

cus

tom

ers

give

s ris

e to

gre

ater

use

of t

rans

port

. (E

) C

omm

issi

on:

1% o

n sa

les

for

quar

ter.

(F

) A

dver

tisin

g: c

harg

ed o

n ba

sis

that

cos

t inc

urre

d in

qua

rter

pri

or t

o sa

les;

cha

rge

for

4th

quar

ter

in r

espe

ct o

fsal

esfo

llow

ing

year

.

l::o

;:: ~

'1> ~

~ 9 ;:::: ~ - ~ '""' \0

Cas

h B

udge

t

Tota

l 1s

t Qtr

. 2n

d Q

tr.

3rd

Qtr

. 4t

h Q

tr.

1\,) ~

Rec

eipt

s:

c::;,

Sal

es-

Cas

h 1,

890,

000

607,

500

585,

000

292,

500

405,

000

:t..

Cre

dit,

61

prev

ious

qtr

. 38

0,00

0 50

,000

13

5,00

0 13

0,00

0 65

,000

s:::

~

this

qua

rter

21

0,00

0 67

,500

65

,000

32

,500

45

,000

iS-

2,48

0,00

0 72

5,00

0 78

5,00

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MASTER BUDGET (Profit and Loss)

Notes Year Jst Qtr. 2nd Qtr.

Sales - Units 49,000 16,000

Sales- Value (1) 2,520,000 810,000

Costs: Materials (2) 1,358,000 434,000 Labour (3) 266,000 86,000 Indirect Salaries 198,700 40,450 Rent and Rates 84,000 21,000 Light and Heat 85,600 20,300 Repairs 53,000 12,900 Insurance 67,900 16,975 Commission 25,200 8,100 Interest 20,000 5,000 Advertising 65,000 20,000 Transport 6,200 2,000 Depreciation 61,600 15,425

2,291,200 682,150

Profit (Loss) (4) 228,800 127,850

Less Taxation 42,000 Dividends (5) 116,000

158,000 Balance for year 70,800

228,800

Notes: (1) Sales: As per sales budget. (2) Materials: 21,000 Units A@ £34

28,000 B@ £23

(3) Labour: 21,000 Units A@ £6 28,000 B@ £5

15,000

780,000

422,000 82,000 63,750 21,000 23,350 14,300 16,975

7,800 5,000

10,000 2,000

15,425

683,600

96,400

714,000 644,000

£1,358,000

126,000 140,000

£266,000

(4) Company is budgeting for a net profit of 9%.

Jrd Qtr. 4th Qtr.

8,000 10,000

390,000 540,000

206,000 296,000 42,000 56,000 45,350 49,150 21,000 21,000 16,350 25,600 12,900 12,900 16,975 16,975

3,900 5,400 5,000 5,000

15,000 20,000 1,100 1,100

15,425 15,325

401,000 524,450

(11 ,000) 15,550

(5) Note forecast dividend (£87 ,000) in view of budgeted year-end bank balance (£31 ,200) company may be relying on cash income in first quarter of following year.



Fixed Assets

Leaseholds Plant Fittings Vehicles

Current Assets Stocks: Finished Goods

Raw Materials Debtors Prepaid Advertising Bank

Current Liabilities Creditors Taxation Proposed dividend

Cost

450,000 370,000 106,000 35,000

961,000

608,000 98,000 90,000 25,000 31,200

148,800 18,000 87,000

Depreciation

99,900 162,600 62,000 22,000

345,600

852,200

253,800

Net

351,000 207,400

44,000 13,000

615,400

598,400

1,213,800

Share Capital Retained profits Debentures

Preparation of Cash Budget

580,000 383,800 250,000

£1,213,800

The Balance Sheet of a company at 31 August is:

Share Capital Retained Profits Trade Creditors Accrued Charges

Rent Others

700,000 240,000

85,000

8,000 6,000

1,039,000

Plant at cost less depreciation

Stocks: Raw Materials WIP and Finished Goods

Debtors Bank

600,000 264,000

336,000

115,000

125,000 300,000 163,000

1,039,000


Creditors represent one month's purchases of raw materials. Debtors represent two months' sales of £150,000 per month. Future policy: Plant costing £200,000 to be purchased and paid for in

September. Raw Material consumption will be:

September 85,000 October 110,000 November 80,000 December 120,000

Stocks of raw materials to be increased to £130,000 at end of September and to £150,000 at end of November.

Expenses during the period will be:

September October/December (per month)

Direct Wages 16,000 24,000 Indirect Wages 5,000 7,000 Other factory expenses 3 ,000 5 ,000 One-quarter of the above expenses will be outstanding at the end of each

month and will be paid in the following month.

Salaries 20,000 22 ,000 Office Expenses 2 ,000 3 ,000 Advertising 60,000 30,000 (Oct/Nov) 10,000 Dec

All the above will be paid in the month in which the expense is incurred.

Rent: £4,000 per month paid quarterly in arrears 30 September and 31 December.

Depreciation is calculated at £7,000 per month.

Forecast sales: September October November December

175,000 200,000 160,000 250,000

Work in progress and finished stock levels: September 125,000 October 160,000 November 195,000 December 175,000


Existing credit terms will apply during the four months. The Bank Overdraft is to be limited to £100,000 and the parent company will

provide loan facilities on a monthly basis when the overdraft is likely to be exceeded.

A budgeted Manufacturing, Trading and Profit and Loss Account is required for the four months to 31 December, together with a forecast Balance Sheet as at that date. A cash forecast is also required for each month showing the monthly bank balance or overdraft and the extent to which loan facilities will be necessary.

Preliminary Workings for Cash Budget

Direct wages Indirect wages Factory Expenses

Sept. * of 16,000 Accrual b/f

Oct.* of24,000 Add accrual b/f

Nov.* of24,000 Accrual b/f

Dec.* of24,000 Accrual b/f

Accruals c/f

£12,000 4,000

16,000

18,000 4,000

22,000 ---18,000 6,000

24,000

18,000 6,000

24,000

* of5,000 Accrual b/f




Direct Wages: Y<1 of 24,000

3,750 *of3,000 1,250 Accrual b/f

5,000

5,250 *of 5,000 1,250 Accrual b/f --6,500

5,250 * of5,000 1,750 Accrual b/f

7,000

5,250 *of 5,000 1,750 Accrual b/f

7,000

6,000 Indirect Wages: Y<l of 7,000 1,750 Factor x Expenses: Y<1 5,000 1,250

--9,000

Cost of material purchased: Sept Oct Nov Dec Raw materials used 85,000 110,000 80,000 120,000 Add Closing Stock 130,000 130,000 150,000 150,000 Less Opening Stock 115,000 130,000 130,000 150,000

:. Purchases 100,000 110,000 100,000 120,000

2,250 750

3,000

3,750 750

4,500

3,750 1,250

5,000

3,750 1,250

5,000

Total 395,000 150,000 115,000

430,000


Budgeted Cash Account

Sept. Oct. Nov. Dec. Total.

Receipts Debtors 150,000 150,000 175,000 200,000 675,000 Parent Co. 28,000 26,000 54,000

203,000 226,000 729,000 Payments Creditors 85,000 100,000 110,000 100,000 395,000 Plant 200,000 200,000 Wages 21,000 28,500 31,000 31,000 111,500 Expenses 3,000 4,500 5,000 5,000 17,500 Salaries 20,000 22,000 22,000 22,000 86,000 Sundries 2,000 3,000 3,000 3,000 11,000 Advertising 60,000 30,000 30,000 10,000 130,000 Rent 12,000 12,000 24,000

403,000 188,000 201,000 183,000 975,000 Balance for month (overdrawn) (253,000) ( 38,000) 2,000 43,000 (246,000) Balance b/f 163,000 ( 90,000) (128,000) (126,000) 163,000

Balance c/f ( 90,000) (128,000) (126,000) ( 83,000) ( 83,000)

Budgeted Manufacturing, Trading and Profit and Loss Account for the 4 Months to 31 December

Sept. Oct. Nov. Dec. Total.

Sales 175,000 200,000 160,000 250,000 785,000 Raw Materials 85,000 110,000 80,000 120,000 395,000 Direct wages 16,000 24,000 24,000 24,000 88,000 Indirect wages 5,000 7,000 7,000 7,000 26,000 Factory expenses 3,000 5,000 5,000 5,000 18,000 Plant depreciation 7,000 7,000 7,000 7,000 28,000

.Factory costs 116,000 153,000 123,000 163,000 555,000 OpeningWIP 125,000 125,000 160,000 195,000 125,000 Closing WIP (125,000) (160,000) (195,000) (175,000) (175,000)

Cost of production 116,000 118,000 88,000 183,000 505,000 Administration 22,000 25,000 25,000 25,000 97,000 Advertising 60,000 30,000 30,000 10,000 130,000 Rent 4,000 4,000 4,000 4,000 16,000

202,000 177,000 147,000 222,000 748,000 Profit (loss) ( 27,000) 23,000 13,000 28,000 37,000

175,000 200,000 160,000 250,000 785,000


Fixed Assets

Plant at cost Less Depn.

Stocks and WIP Debtors

Creditors Accruals Overdraft

Capital Retained Profits

Loan

Questions

Forecast Balance Sheet as at 31 December

800,000 292,000

325,000 410,000

735,000

120000 9000

83000 212,000

508,000

523,000

1,031,000

700,000 277,000

977,000

54,000

1,031,000

10.1 A clothing company manufactures ready-made clothing for men. They have considerable production problems due to fluctuating demand. Sometimes they find that they have too much stock of some items and not enough of others, and lose profits in consequence. It has been suggested to them that they would benefit considerably by installing a system of Budgetary Control. They invite you to prepare for them a Budgetary Control system to be brought into use the following year, and give you access to all their records and books of account.

Estimates of costs are prepared to enable the company to fix selling prices. They have their own retail shops and do not sell through any other organisa

tion. The following information is based upon past records and historical costs:

Expected sales for next year:

Product Suits, A Quality Suits, B Quality Overcoats, A Quality Overcoats, B Quality Summer Jackets Summer Trousers

Code no. 1 2 3 4 5 6

Selling Price

£30.00 £23.00 £32.00 £24.00 £15.25 £ 8.45

Quantity Jan-Mar. Apr.-June Jul-Sept.

4,000 3,000 2,400 5,000 5,400 3,800 2,000 500 800 3 ,200 800 1 ,000 1,000 5,000 10,000 1 ,200 6 ,000 11 ,000

Oct-Dec. 3,600 4,800 3,200 5,000

500 800


Unit Cost of Production

This is based upon the following estimates: Product Materials Direct Labour

Cloth Lining Buttons Hrs.@ Hrs.@ Qty. Price Qty. Price Qty. Price Grade A Grade B

Code 1 3 yds £6 1 yd. £1.50 1 doz 20p ~ SOp 1 60p 2 3 yrd £4.50 l yd. £1.40 1 doz 20p ~SOp l 60p 3 3 yds £6.50 l yd. £1.50 'h doz 20p 'h SOp % 60p 4 3 yds £4.25 1 yd. £1.43 'h doz 20p 'h SOp % 60p 5 l'h yds £6 'h yd. £1.40 'h doz 20p Y,. SOp '% 60p 6 1 yd £4.50 'h yd. £1.60 'h doz 20p Yo SOp ~~ 60p

Stocks: Opening stock for next year expected to be-Raw Materials: Total Value, at cost, £20,000 (including Work in Progress, which is fairly small).

No change is expected in the closing stocks, so that purchases will equal estimated production.

Finished Goods: These are valued at the Factory Cost.

Opening Stock: dosing Stock:

Code

1,000 800

2

1,000 1,200

3

800 780

4

800 820

5

500 320

6

600 320

Production of each product has to be adjusted throughout the year to produce sufficient jackets and trousers in the summer, after which labour has to be employed more on overcoats for the winter.

Overheads: Factory Overheads are recovered by adding 100% to Direct Labour. Adminstration and Selling and Distribution Overheads are recovered together by adding 25% to Factory Cost.

Machine Hours: Sewing Cutting

~~ 1 2 3 4 5 6 ~hr. ~hr. ~hr. ~hr. 12 mins. 12 mins.

3 mins. 3 rnins. 3 mins. 3 rnins 1 min 1 min

The factory works a 40-hr. week for 48 weeks a year. There are 20 sewing machines and 3 cutting machines. 10% of the hours available is allowed for normal maintenance, cleaning and

setting-up time, 8 men are engaged in the cutting department, but only 2 use the cutting

machines and act as supervisors in the preparation and marking of the cloth for cutting.

There are 35 workers in the sewing, pressing and fmishing department, of whom 6 are supervisors.

So there are 8 supervisors who are paid 80p an hour, while the rest are paid 60p an hour. These are all regarded as direct wages.

The overheads for next year are expected to be:


Factory Admin. Selling Distn.

Rent and rates 4,000 1,000 3,000 1,000 Depreciation:

Lease 4,200 1,600 800 400 Plant and Mach. 1,012 Fix. and Ftgs. 788 200 200 84 Motor Vans 1,516

Lighting and Heating 2,000 1,000 1,500 300 Debenture Interest 3,200 Power 2,500 Wages and Salaries 14,000 30,000 42,000 4,000 Insurance 400 200 1,500 400 Repairs 600 300 1,000 200 Commission (2%) 12,600 Mise. Expenses 500 3,300 2,400 260

Totals £30,000 £40,800 £65,000 £8,160

During the following year it is proposed to buy a new motor van in January at a cost of £5,000, and 2 new sewing machines at £8000 each in April; new Office Equipment costing £4,000 in July.

Summarised Balance Sheet at the end of the cu"ent year

Auth. and Issued Capital Fixed Assets 100,000 Ord. £1 shares 100,000 Leasehold Premises 210,000 General Reserves 50,000 Less Depn. 70,000 140,000 Bal. on P. and L. a/c 9,500

Plant and Mach. 10,000 · 8% Debentures 40,000 Future Taxation 22,500 Less Depn. 3,000 7,000

Motor Vans 6,080 Cu"ent Liabilities Less Depn. 1,200 4,880 Trade Crediotrs 32,400 Fix and Ftgs. 16,760 Accrued Expenses 3,700 Less Depn. 3,760 13,000 Current Taxation 14,500*

164,880 Proposed Ord. Div. 9,400 60,000 Cu"ent Assets. Stock 50,120

* £7,900 due 1 Jan. Debtors 56,000 £6,600 due 1 May Cash 11,000

117,120

£282,000 £282,000

Notes: Half the sales are credit sales and the average time for payment is one month. Trade creditors and expense creditors are paid one month in arrears. (Expense crs. consist of all the overheads except depreciation, wages and salaries,


and debenture interest). The ordinary dividend is paid in May. Tax is due in January. Debenture Interest is paid 30 June and 31 December.

It is proposed to pay an interim dividend of 12% in October. The sum of £28,000 is to be provided for Future Tax, Final Ordinary Dividend of 20%.

10.2 l11e XYZ Engineering Co. Ltd. proposes to increase its output by reorganisation of the factory layout, installing additional plant and increasing the labour force. The company mtends to put the plan into effect during the first four months of its financial year.

The Balance Sheet as at the close of the year was:

Ord. Share Capital Retained Profits

Plant, at cost less depn.

Stock:

600,000 264,000

Raw materials 115,000 WIP and Fin.Gds 158,500

Debtors 300,000 Cash 163 ,000

700,000 240,000

940,000

336,000

736,500

Creditors Accrued:

1,072,500 85,000

Rent Others

Taxation Prop. Dividend

8,000 6,000

30,000 3,500

132,500

940,000

Debtors represent sales for the previous two months at the rate of £150,000 per month

Creditors represent purchases for one month

Sales in the next four months will be

Sept/Oct Nov. Dec.

£170,000 p.m. £180,000 £250,000

{1) Additional plant will be delivered in Sept. at a cost of £200,000 payment being made in Nov.

(2) Raw material consumption will be : Sept £70,000 Oct/Dec £100,000 per month.

{3) Stocks of raw materials to be increased as follows: end Sept. £180,000;end Nov. £150,000.


(4) Factory costs will be: Sept. Oct/Dec. Direct Wages 16,000 24,000 Indirect Wages 5,000 7,000 per month Factory Overheads 3,000 5,000

One quarter of the above will be outstanding at the end of each month and will be paid in the following month.

(5) Rent at £6,000per month is paid quarterly in arrears at 30 Sept and 31 Dec.

( 6) Admin and selling expenses will be: Salaries: Sept. and Oct 20,000 per month Advertising Sept and Dec. 10,000 per month Office

Nov/Dec. 22,000 per month Oct/Nov. 30,000 per month

Sundries Sept and Dec. 12,000 per month Oct/Nov. 13 ,000 per month (7) Work in Progress and Finished Goods stocks are to be:

Oct. £260,000; Nov. £275,000; Dec. £175,000. (8) Present credit terms will still apply. (9) The parent company will advance by way of loan sufficient funds to

maintain any required overdraft at a level of £300,000.

Prepare a cash forecast for the four months, showing balance at end of each month and a P and L a/c showing estimated results for the four months and a forecast Balance Sheet as at 31 Dec.

CHAPTER 11

Accounting for Costs

Trading organisations who are supplied with a finished product for resale are aware of the cost of the product and will know from market research, or have been informed by the manufacturer of a possible selling price. The trading company will be aware that in order to earn a profit its expenses must be maintained within the margin between cost and selling price.

The manufacturing company, however, having ascertained a possible selling price, knows that profit can be earned to the extent to which the costs of producing the product can be kept down.

Cost accounting thus becomes an essential requirement to any organisation supplying a finished product to a third party, and a system of costing would be used by the following:

(1) Manufacturers- to ascertain the costs of alternative products. (2) Farmers - to ascertain the costs of alternative forms of livestock or

crops. (3) Hoteliers- to ascertain the cost of providing service. (4) Transport operators - to ascertain the costs of providing alternative

forms of transport.

All these organisations will require a costing system as an aid to management planning and control; in order that decisions as to number and variety of articles to be produced can be made.

The following are the distinctions between fmancial and cost accounting.

Financial accounting Is a legal necessity Shows the total result of a number of

operations Information basically historical Expenses analysed by type Indicates fmancial state of business,

e.g. state of assets. Used by all organisations

Cost accounting No legal requirement Shows the result of each individual

operation Attempts to forecast future results Expenses analysed by departments Indicates state of individual opera-

tions but is no indication of overall 'health' of company. Used only by those providing a finished product or service.


The above comparison does not imply that where both fmancial and costing systems are in use in the same organisation it is necessary to maintain the information in two separate systems. Where the information can be integrated in one ledger this has the advantage of eliminating duplication of entries and avoids the necessity for reconciliation of profit indicated by the financial ledger and the profit shown by the costing ledger. Such differences usually arise from the fact that some administration expenses may not have been notified to the costing department and also from the manner in which the costing section deals with expenses.

Irrespective of the type of organisation, final costs are obtained in the same manner.

Direct Materials

Quantity and cost obtained from a material specification prepared by engineer, designer or chemist - a farmer will be aware of materials required to feed an animal for a given period.

Direct Labour

Type or grade and manner of carrying out operations obtained from a study of preparing samples by operators. Layout of work done in co-operation with work-study engineers and factory management.

Direct Expenses

Costs not arising in the actual production of a commodity but are an essential part of the marketing of the product, e.g. the Cellophane wrapping and carton for breakfast cereals, the royalty paid to authors.

These costs may arise either as a result of manufacture by the producer of the commodity or by obtaining supplies from an outside source or as a result of negotiation with the party concerned.

The costs summarised above will always be calculated on the basis of a single unit or such quantity as is considered economic, and once this cost is calculated it should not vary, irrespective of quantity produced.

Material cost will have been agreed with a supplier for a given quantity to meet anticipated production.

Labour costs will have been agreed, taking into account the agreed time required and the rate for a supply of a specific type of labour.

Overheads, the expenses of running the organisation, are however incurred in the operation of a number of departments or a variety of products. Management wishes to ensure that all potential customers are charged with a proportion of the expenses. There is however no satisfactory method for ensuring that all products are given an equitable charge for overheads. These will vary on a unit basis depending on levels of expenditure and production.

Costing information, even though it may come from a different source to fmancial information, is summarised and controlled through total accounts in exactly the same manner as financial information.

Accounting for Costs 253

The distinction between financial and costing is shown as follows:

Income Statement

Sales 100.000 Cost of Goods sold 68,000

Gross Profit 32,000 Expenses 22,000

Profit £10,000

Costing Statement

A 8 c Total Sales 36,000 19,000 45,000 100,000 Factory 32,000 13,000 25,000 70,000 Costs

Admin. 5,000 9,000 6,000 20,000 Costs

37,000 22,000 31,000 90,000

Profit (Loss) (1',000) (3,000) 14,000 10,000

Management now has a decision to make as to whether the loss leaders should not be produced or if an investigation is required into the manner in which products A and 8 are produced. Are the apparent losses the result of the manner in which the administration costs and possibly some part of the factory costs were apportioned to the various products?


The estimate and eventually the cost of a product may be presented as follows:

Cost of Raw Materials (in accordance with stores requisitions or material specification)

Cost of Direct Labour (as per time cards or work study)

Direct Expenses (Royalty as per contract) (Carton as charged)

Prime Costs Variable expenses

(Consumable stores, Power) Fixed Costs

(Depreciation, Works Director's salary)

Indirect factory costs

Cost of Production Office and Admin.

Fixed costs, (Accountant's salary)

Selling and Distribution Variable costs (Commission)

Fixed Costs (Sales Manager's salary)

Total cost Selling Price

Profit 16%

The fixed costs were charged on the agreed basis of:

60

150

20

60

Estimated total expenditure

Estimated total production

250

500

350

1100

210

1310

290

80

1680 2000

£320 --

If production of this product does not reach required level the expenses charged to customers will be less than actual expenses. Similarly if expenses exceed estimate and production is in accordance with estimate, the charge to customers will be less than expenses incurred.


Characteristics relating to stock and their valuation in mrious organisations.

Retailer Wholesaler Manufacturer

1. Finished goods only

2. Variety of stocks, many small commodities

3. Supplies from one wholesaler or number of manufacturers

4. Will order as considered necessary or as a result of visit from a representative of wholesaler or manufacturer

5. little or no attempt to maintain stock records. Stock at year end probably based on gross profit margin

6. Cost of goods sold and stock valuation probably inaccurate

Finished goods only

Variety of items but probably in bulk

Supplies from a variety of manufacturers

Attempts to anticipate demand. Ensures supplies available when required by retailers

Should have stock records; stores not difficult to control

little difficulty in ascertaining value of stock or cost of sales

Raw materials, partly completed items, finished stocks. Large variety of components

Supplies from a variety of sources

Has to arrange supplies in anticipation of production and production programme in anticipation of sales

Detailed stock records essential to control varying types and levels of items, and to ensure production flow

little difficulty in ascertaining cost of raw materials used, and stock values; may have problems with materials at varying prices

Requires a system of inspection for raw materials

Stocks of partly finished goods necessary due to inability to complete production on a one-off basis

Stocks of finished goods necessary to satisfy wholesalers and retailers

Each stage will require stock records

Costs readily identifiable


Summary of Purchasing and Stores Procedure

Purchasing Procedure Purchase requisition from individual requiring goods, or from storeman when

stock reaches re-order level to purchasing department. Quotations obtained from potential suppliers. Order placed with successful tenderer taking into account quality, delivery,

price, minimum order quantities. Follow-up of supplier to ensure delivery dates maintained. Arrange: inspection on receipt; transfer to stores or requisitioner; return to

supplier of faulty goods.

Problems of Purchasing Department

Must consider: costs of initiating order; cost of storing; economic ordering levels; maximum/minimum stock levels; delivery time/production usage; delivery time by supplier and for customer; costs of stock holding; allocation of stock as between specific customers and general stock.

Stores Procedure

Receive goods from inwards inspection; arrange storage and up-date stock records; issue stores on authority of requisition and accept return of surplus stores - up-date records; notify purchasing department when stock at re-order level; carry out stock counts as required, or supervise stocktaker and adjust stock card balance where necessary.

Problems of Storing

The manufacturing system in operation -job/batch/process; disposition of plants - centralised system or several depots; variety of supplies, size and quantity, type of storage necessary; storage of specialist supplies - refrigeration, etc., fire risk.

Stock Card

This may contain quantity details only - fmancial record maintained by accounting office will then include value of stores.

Date Qty. Cost Value Out Qty. Cost Value Bal. Cost Value in Ref (£p) (£p) Ref (£p) (£p) (£p) (£p)

1/10 100 £1 £100 100 £1 £100 3/10 300 SOp 240 400 85p 340 7/10 1000 85p 850 1400 85p 1190 13/10 1400 90p 1260 2800 8711zp 2450 20/10 900 87% 787.501900 1662.50 27/10 1800 87% 1575 3700 87% 3237.50

Accounting for Costs 25 7

Total of receipts will agree with entries in stores accounts and suppliers' invoices. Total of issues will agree with material requisition summaries. Value as shown will agree with balance on stores account.

The system is known as perpetual inventory, due to the fact that the balance at any one time can be seen immediately. It gives a control over stock levels and enables book stock and physical stock to be agreed without difficulty. Where differences arise at stocktaking the stock card must be adjusted and the fmancial value entered in the Stores Account and carried to the Stock Adjustment Account for subsequent transfer to final accounts.

The pricing method is known as 'the weighted average cost'. The quantity and value on hand is added to quantity and value of next delivery to give an average price.

Pricing of Stores

Generally, the storeman is not concerned with the order in which stores are used-items will be boxed and taken as requested without regard to the date of receipt. The accountant is concerned to take the cost of stores used from the Stores Account and will have to decide the order in which various prices are applied.

Methods

Average Price

This can be applied as the average of a number of different prices not yet fully utilised, or as the average price of all stocks in hand when a delivery is received at a price different to the previous price.

Problems

Numerous calculations are involved if deliveries are frequent and at varying prices. The average price may, however, be a reflection of the latest price if stocks move frequently, or if the latest purchase is large enough. It is possible for several issues to be priced at the same value, leading to uniformity in the costing of materials.

First in First Out (FIFO)

This is sometimes referred to as 'Price Queueing'. The oldest price at which stock was received is used in priority to all other prices. When all stocks at that price are utilised the next oldest stock price will be used.

Problems

Numerous calculations of individual issues may be involved if receipts are in small quantities. The stock balance will be at more than one price, but may bear a relationship to the most recent price.

258 A Foundiltion in Business Accounting

Last in First Out (LIFO)

This is sometimes referred to as 'Price By-Passing'. The latest price at which purchases are made is the first price to be utilised when stock used has to be priced. Earlier prices will only be used when later prices are exhausted.

Problems

This method is also likely to involve numerous calculations. The stock value will be at an out-of-date price. Customers bear the most recent charge. Both FIFO and LIFO have the disadvantage of no uniformity in costs charges; comparisons between similar jobs are made difficult. Under both methods the valuation of issues and stock is at actual cost.

Standard Price

This is a fictitious price - the price at which stock should be purchased. All usage is priced at the same value.

Problems

It avoids individual calculation. It is necessary to account for the difference between the actual price paid and the standard price. Stock will not be at cost or market value - this must be adjusted in accordance with the variance in the year. The system aids the preparation of preprinted bulk requisitions and is also an aid to controlling purchasing department efficiency.

Comparison of Pricing (see stock card, page 256)

Stock Issued FIFO

100 @£1 100 300@ 80p 240 500 @85p 425

900@90p

900 Units consumed £765

Stock remaining 100@ £1 300@ 80p

500@ 85p 425 1000 @85p 1400 @90p 1260 500 @90p 1800 @87~p 1575 1800 @87~p

-- --3700 Units £3260 .3700

LIFO

810

£810

100 240 850 450

1575

£3215

The method of stores pricing is a matter for the accounting policy of individual businesses and once decided should be adopted consistently. Irrespective of the stores pricing method adopted, the closing stock must be valued in accordance with recommended practice, i.e. the lower of cost or net realisable value, examining each individual item or group of items and not the stock in aggregate.

Accounting Entries

Cost of purchases of Raw Materials (As per Suppliers' invoices. Totals from invoice summaries)

Quantities taken into stock being entered on stock cards

Stores previously issued to factory now returned as surplus to requirements. (At original cost - shown as receipt on stock card)

Financial value of stock count surplus (Stock card balance increased)

Balance b/d

Cost of goods returned


Stores Account

Cost of Returns to suppliers XX XX (As per invoices to

Creditors. Totals from Summary sheets)

Balances on Stock card will be reduced. (Unless goods returned prior to acceptance by stores)

Cost of Materials issued to factory for production XX (Totals as per summaries of Material Requisitions)

XX Financial value of stock losses XX

(Stock card balance reduced) XX

Balance being value of stock in hand c/d XX (Will be agreed with value of stock in aggregate on stock cards)

Creditors

XXX Cost of Supplies as per Invoices XX

Materials Used (Work in Progress)

Cost of Materials withdrawn from Stores for production XX

Cost of Materials returned to Store

Value of Materials used in completed production transferred to Finished Stock

Balance - Materials still on Factory Floor - Work in Progress

XX XX

XX

Stock Adjustment

Financial Value of stock XX Financial value of stock XX losses surpluses.

Difference to Profit and Loss a/c Difference to Profit and Loss a/c


Salient features of Statement of Standard Accounting Practice No.9

Valuation of Stocks and Work in Progress

Costs must be set against expected revenue. Any costs not recoverable in future years must be charged against current year's revenue.

Stocks

Compare cost and net realisable value of each item or groups of items not in total.

Costs to include any expenditure necessary to bring product up to required condition.

The problem of retailers - the inability to take stock or ascertain true cost; may use selling price less normal margin.

Net realisable value - the price which would give rise to neither profit nor loss on sale.

Replacement cost - only used if lower than net realisable value provided any loss which may arise is not excessive.

How to describe in fmal account - 'At the lower of cost or net realisable value', with a note as to the accounting policies used in arriving at the value stated.

Long-Term Contracts

Deferring profit until completion may distort accounts, which would show result of contracts completed and not of year's activities.

Profit to be taken in relation to proportion of contract completed, bearing in mind possible future liabilities.

Possible losses to be provided in full. Can a profit be reasonably foreseen at end of contract? Show as 'at cost plus attributable profits or less attributable losses and

progress payments received and receivable'. Separate note required of amount of progress payments.

Terminology

Stocks and Work in Progress: assets purchased for resale; consumables; raw materials to be incorporated in resaleable products; items in varying stages of completion; finished items.

Cost of Purchase: purchase price, import duty, transport and handling. Trade discounts, rebates and subsidies can be deducted.

Cost of Conversion: direct materials, direct labour and direct expenses, subcontract charges and production overheads.

Production Overheads: those charges relating to production as distinct from administration, selling and distribution charges.

Net realisable value: actual or estimated selling price less costs required to complete, and marketing and distribution costs.

Long-term contract: any contract where time required to complete will exceed one year.


Absorption of Overheads

Although the expenses of an organisation are incurred by every department within the organisation, these expenses can in tact only be recovered from customers through the efforts of the productive departments. Management may wish to allocate the expenses to departments, individuals or machines to ascertain the costs of running these departments or cost centres. The ultimate intention is to charge the expenses to production.

A preliminary step may well be the preparation of an expense distribution statement, where the expenses are apportioned or allocated to individual departments on an agreed basis.

The overheads are then transferred to production departments or products and a recovery rate calculated on one of the following bases: (1) overhead as a percentage of direct material; (2) overhead as a percentage of direct labour; (3) overhead as a cost per direct labour hour.

Where there is more than one productive department it is possible to have a different rate for each department calculated on a different basis.

The following information is required for the calculation of an overhead recovery rate:

Anticipated sales in units. Direct labour and/or machine hours per unit. Direct material cost per unit. Direct labour cost per unit. Overheads either in total for whole organisation or for each productive department.

Department or Product A B c Total

Anticipated Sales Units 250,000 100,000 50,000

Direct Labour Hours per unit 4 2 1

Total hours 1,000,000 200,000 50,000 £1,250,000 Direct Material

£per unit 8 4 1 Total Material cost 2,000,000 400,000 50,000 £2,450,000 Direct Labour

£per unit 4.80 2 2.625 Total Labour cost 1,200,000 200,000 131,250 £1.531.250

Total Overheads £6,125,000

Where material prices and labour rates increase they will have no effect on overheads. A recovery rate based on either of these methods will have an additional effect on cost, as a result of increasing overhead charge in addition to increases in direct costs.


Overhead recovery rates: Estimated expenditure £6,125,000 _ Ef'<s:::Lt..-::im::-a:-:;:t,.,-ed...--:rdt.-:'· re'::-:c::7tTia:-rb-=o~u-::-r rh~ou::-r:=-s---,1~2"'5~ono'VOV>O - 4 ·90 per hr ·

Estimated expenditure Estimated material cost

' '

£6,125,000 = 250% £2,450,000

or £2.50 charged for overheads for every £1 of materials.

Estimated expenditure Estimated direct labour cost

or £4 charged for overheads for every £1 of labour.

The cost of product A would appear as: Direct Materials 4 tons @ £2 per ton Direct Labour 4 hrs. @ £1.20 per hr Overheads 4 hrs.@ £4.90

Total cost Selling price (say)

Profit

£6,125,000 = 400% £1,531,250

8 4.80

19.60

32.40 50,00

£17.60

If the job requires longer than the estimated 4 hours, additional overheads will be charged thus reducing profit, where the selling price is fixed. Where a job exceeds the time anticipated the possibility is that more overheads are in fact incurred, e.g. additional power. It is therefore essential that these be recovered.

The cost of a job is estimated as follows:

Materials Labour Overheads

5 tons @ £200 per ton 30 hrs.@ £5 per hr. @ 250% on Materials

1,000 150

2,500

£3,650

If during the course of production the supplier increases his price by 25%, the position will be :

Materials 2 tons @£200 400 3 tons@ £250 750

I ,150 11~% Incr. Labour 30 hrs.@ £5 150 Overheads @ 250% on Materials 2,875 15% Incr.

£4,175 --Total cost has increased by 14% as a result of charging additional overheads,

even though material price increases will not attract further overheads. The business will have recovered additional overheads not represented by

additional costs.


Similar considerations will apply if the overhead recovery rate is based on labour costs. A negotiated pay increase will not give rise to additional overheads.

Neither of the above systems will recover additional overheads arising as a result of the factory operating for more hours than expected or overhead costs being greater than budgeted costs, unless a review of the recovery rate is carried out periodically.

A recovery rate based on labour houi:s acknowledges that where a job tan.es more or less time than anticipated this may have some effect on total overheads as a result of (a) movements in factory hours affecting costs of power, light, heat, etc.; (b) additional supervision and clerical staff required; (c) changes in depreciation charges as a result of more or less operating time.

Considering the original example and assuming a 25% material and a I 0% labour cost increase with recovery based on labour hours:

Estimate: Materials Labour Overheads 30 hrs@ £4.90

Materials as previously Labour 10 hrs. @ £5

24 hrs @ £5.50 Overheads 34 hrs. @ £4.90

50 132

1,000 150 147

£1,297 = Increase on Estimate

1,150 11%%

182 21% 166.60 13%

£1,498.60

Total costs have increased by 16%% but overheads charge is only affected by the additional 4 hours, this accounting for 9% of the increase in costs. Other increases have not affected overhead charge.

The manner in which overheads are recovered is a matter for decision by the individual business, the main consideration being to ensure that all overheads are eventually charged to customers. An organisation may decide to ascertain the costs of a particular section or department; whilst some overheads will be directly attributable to the department other costs can only be apportioned and this will have to be done on an arbitrary basis, e.g. welfare services on the basis of number of employees. Where productive departments use the services of nonproductive departments the extent of usage can only be estimated.


An organisation may also decide to separate overheads by type and apportion each on a different basis:

Factory Overheads: Budgeted expenses = Rate per hour Estimated hours

Admin. Overheads: Budgeted expenses x 100 = % of Factory cost

Budgeted factory costs

Advertising: Budgeted expenses

Budgeted sales revenue x 100 = %per £1 of Sales

Selling: Budgeted expenses

Budgeted sales revenue x 100 =%per £1 of Sales

Distribution: Budgeted expenses

Estimated total weight

The cost estimate would appear as:

Materials Labour Factory

5 tons 30 hrs.

Overheads 30 hrs.@ 25p

Admin. Overheads @ 200% of Factory Overheads

Advertising 5% of Selling Price Selling 3% of Selling Price Distribution@ £2.50 per ton

Profit

Selling Price

= £ per ton carried

1,000 150

7.50

1,157.50

15.00 70.00 42.00 12.50

1,297.00 103.00

£1,400.00

Overheads amount to £14 7. Irrespective of method adopted for recovery the total overheads will remain the same.

Accounting for Overheads

Stage 1 - calculation of an overhead recovery rate for each productive department, based on estimated costs and production.

Estimated Overheads Estimated Hours Overhead Rate per hr.

1 18,000

900 £20

Department

2 16,000

1,000 £16


Stage 2 - overhead expenditure as incurred charged to respective accounts and overhead recovered charged to Work in Progress as production proceeds.

Dr. Overhead Expense l Actual Expense

Cr. Creditors Dr. Work in Progress l

Actual Recovery Cr. Overhead Recovery

Stage 3 - account for difference (the variance) between actual costs and recovery.

Department

Actual results: 1 2 Expenditure 19,087 15,314 Hours 876 1033 Actual recovery @ £20 17,520 @£16 16,528

--Variance {£1 ,567) £1,214

-- --The under- and over-recovery has arisen as a result of (a) expenditure more

than budget; (b) expenditure less than budget; (c) productive hours less than budget; (d) productive hours more than budget. -

Reconciliation of Variance Department

1 2 Budgeted Expenditure 18,000 16,000 Actual Expenditure 19,087 15,314

(Over)/Under Budget {1 ,087) 686 Anticipated Hours 900 1,000 Actual Hours 876 1,033

Production Variance 24 hrs. 33 hrs. @£20 @£16

Over/(Under) Recovery {480) 528

£( 1 ,567) £ 1,214

The method used for recording the costing information may depend on the type of business or the manner in which the management want the information to be presented.

The example below presents the information on the basis of (a) ascertaining the cost of individual containers, or (b) ascertaining the cost of a department or process.

Both methods employ the same documentation and total direct costs and overheads remain the same.

An account, or job, would be opened for each container to which the costs would be charged. A cost record is commenced for each job, even though the


same customer may be supplied with similar equipment at intervals. The cost of each job may vary due to (i) changes in material content and price; (ii) changes in type of labour and hourly rate; (iii) changes in work plan leading to variations in time.

The cost record may also cover the cost of a job involving a considerable number of units where these are repetitive, as in the light engineering industry. The job consisting of the manufacture of television sets in batches and costs will be collected for sections, or sub-assemblies, of a complete unit. The costs of the various sections are eventually collected together to ascertain the average cost of a unit.

Where the job is still in progress at the end of a financial period the balance on the account will be included among the current assets on the Balance Sheet. Profit will not be taken or cash received until the job is sold at the agreed price.

Where the job is of a long-term nature and payments are made in respect of completed sections of the job a calculation will be necessary indicating the profit to be transferred to the Profit and Loss Account.

Planning Ltd manufactures containers for a shipping agent and this involves three processes: frame building, cladding and painting. Being a small firm it does not manufacture containers unless it receives a specific order, which is then constructed as a one-off job.

The following was the Manufacturing Account of the business which was produced by the accountant.

Manufacturing Statement for the year ended 31 March

Opening Stock of Raw Material Purchases

Less Closing Stock of Raw Materials

Materials Consumed Direct Labour

Prime Costs Manufacturing Overheads

Factory Rent and Rates Lighting and Heating Factory Insurance

Depreciation: Building Dept. Cladding Dept. Spray Shop

Administration of Production Wages General Expenses

Total Cost of Production

400 150 50

100 70

130

2,500 3,600

600

300

6,100

140 1,160

1,300 220

l ,080 1,780

2,860

7,000

£9,860


The firm built 5 containers in the period under review and the jobs were numbered 20c, 2lc, 22c, 23c, 24c. An analysis of the Materials showed:

Job 20c 21c 22c 23c 24c Total

Frame Manufacture 50 60 70 80 60 320 Cladding 110 120 115 170 175 690 Spraying 10 16 13 19 12 70

170 196 198 269 247 1,080

An analysis of the labour showed:


Dept. Frame Manufacture 200 200 210 220 190 1,020

Cladding 120 130 135 115 110 610 Spraying 20 25 30 35 40 150

340 355 375 370 340 1,780

The spray shop took up 20% of the floor space while the other two departments shared the remaining space equally. Administration expenses of production were considered to be shared equally by each department or by each

container built. There was no Work in Progress at either the beginning or end of the period.

Product or Job Costing


Materials Frame 50 60 70 80 60 Cladding 110 120 115 170 175 Paint 10 16 13 19 12 - ---

170 196 198 269 247 1,080 Labour

Framing Dept. 200 200 210 220 190 Cladding Dept. 120 130 135 115 110 Spray Shop 20 25 30 35 40

340 355 375 370 340 1,780

Prime Cost 510 551 573 639 587 2,860 Overheads

(Equally divided 1400 1400 1400 1400 1400 7,000 £7,000)

Total Costs 1910 1951 1973 2039 1987 9,860 ----


Process Costing

Frame Bldg. Cladding Spraying Materials Consumed 320 690 70 1,080 Direct Labour 1020 610 150 1,780

Prime Cost 1340 1300 220 2,860 Factory Overheads

Rent and Rates 160 160 80 Electricity 60 60 30 Insurance 20 20 10

240 240 120 600 Depreciaion 100 70 130 300 Administration 2033 2034 2033 6100 7,000

3713 3644 2503 9,860

Management are made aware of the costs of each process or department and will ascertain the average cost per container in each department as follows:

Frame Building Costs £3,713 742.60 Frames 5

Cladding Costs £3,644 728.80 Frames 5

Spraying Costs £2,503 = 500.60 Frames 5

Cost per unit £1,972,00

This compares with costs varying between £1,910 and £2,039 under the job costing system, due mainly to the different method used for the allocation of overheads.

Costs of individual jobs will be summarised through a Works in Progress and when sold the cost is transferred to cost of production in order to calculate the profit.

Material Summary Labour Summary Overheads Summary

Balance b/d

Work in Progress

1,080 1,780 7,000

9,860

Nil

Cost of completed jobs

Balance c/d

9,860

Nil

9,860

Balance will represent cost of uncompleted jobs at end of a financial period.


From Work in Progress Profit

Balance b/d

Cost of Production

9,860 927

10,787

1,987

Sales 4 Containers Balance

The balance represents cost of container 24c remaining in stock.

8,800 1,987

10,787

The system of recording costs depends on the particular information management requires. Does it want to know the individual cost of each container constructed? Does it want to know the cost of individual processes?

If a job costing system is used management would be aware of variance in the total cost of identical containers. These variances will arise from:

(1) Price changes in materials and differing quality, leading to additional wastage.

(2) Labour rate changes and differing grades available to that budgeted for, leading to variances in time and total cost as a result of unskilled work.

(3) Accuracy of overhead absorption method. The overheads allocated to the individual jobs bear no relationship to time, material or labour costs.

Under process costing management is informed of the average cost of a complete unit and departmental costs. Production may be that a partly fmished item is placed in store until facilities are available for the subsequent process to be carried out. Where management is in a postion to sell partially completed units (e.g. an unsprayed container) the average costs will be known at the various stages. With process costing management is not informed or does not wish to know the actual cost of a complete unit.

Where a job extends beyond a financial period the business will have to consider the extent to which profits can be assumed to have been earned in the financial period in which part of the work was completed and invoiced; for example, where a building is partially completed the consulting engineer will certifY the amount of such work which will be invoiced to the customer. The builder must now decide the amount of profit relating to the invoiced work which he can prudently take as profit in the financial period.

Even though a profit has been calculated the extent to which this can be used to meet dividends and loan interest will depend on the availability of cash. The builder will also have had to meet costs not yet invoiced in order to complete the work.

Accounting Procedure for Job Costing

Procedure. Estimate prepared - an attempt to find a profitable selling price: (1) material specification drawn up setting out components or raw materials required; (2) sample or plans examined to decide type and grade of labour


required and time needed to complete; (3) basis on which factory and administration overheads are to be charged to job is agreed.

Documents required. (1) Material requisition authorising withdrawal of components from store - unless components specially ordered in when charged direct to job; (2) time card for each operator working on job indicating time spent and cost in a particular financial period, usually weekly.

Material requisitions are priced by the cost office and summarised periodically, the total charge for materials for each job being charged to the account of the customer concerned:

Cr. Stores Control } . D W k . p Total value of all productive stores r. or m rogress

The individual jobs will be charged with their respective portions of the total. Time cards are similarly priced and the total agreed with the payroll. Will be analysed by job as for materials:

CDr. WWageks .copntrol } Total value of all productive wages r. or m rogress

The individual jobs will be charged with their respective portions of the total. No documents for charging of overheads. Each job is charged with its proportion at the agreed date as necessary, i.e. on completion of job:

DCr. 0WorkhindPrCogress1}Total overheads to be charged for period r. ver ea ontro

On completion of the job, the constituent parts of the account are totalled and the final cost ascertained, and a sales invoice completed charging the work to the customer - note that in cert~'n instances the detail of the work done, with the job card, may be part of a ~~t of forms and the invoice is completed as work carried out.

Reqn. No.

0243 0244 0245 0246 0247 0248 0249 0250

Material Requisition Summary W/E 31 March

Job No. 123

15 28

24

67

£134

Job No. 124

22

58

£80

Job No. 125

60

95

£155

Total

£369


Labour Card Summary W/E 31 March

Operator No. Job No. Job No. Job No. Total

123 124 125 Hrs. £ Hrs £ Hrs. £ Hrs. £

638 6 8 20 25 18 22 44 55 644 8 12 10 12 34 20 52 44 690 15 20 18 26 11 15 44 61

---29 40 48 63 63 57 140 160

---Accounting Entries

Dr. Cr. Work in progress 369

Raw Materials 369 Value of Stores issued

per requisitions Wages Control (say) 253

Bank (say) 253 Total of Wages Paid Work in Progress 160

Wages Control 160 Cost of direct labour per

job cards (Note that balance of wages will have been charged out to the respective overheads a/c's) Work in Progress 420

Overheads Recovery 420 Value of recovery as per

labour summary 140 hrs. at £3 per hr.

The above totals are supported by the entries in the individual jobs (or accounts).

Cost Record JobNo. 123 Description of job: Customer:

W/E Material Labour Overheads hrs. at £3 per hr.

31 March 134 29 40 87 7 April 68 75 128 225

£202 104 £168 £312

Estimate Final Cost Materials 190 202 Labour 175 168 Overheads 273 312

£638 £682


Final cost is greater than original estimate - investigate differences -Materials: quantities used greater than estimated - may be due to excessive waste or losses.

Supplier's prices increased or purchases made in small quantities. Labour: Time taken longer than estimated, this may be due to use of different

grade oflabour. Cost reduced by using unskilled labour. Overheads: Increased charge due to time factor - job required 104 hours

compared with estimated 91. The result of using a different system of production to that originally intended.

The problem of profit-taking under long-term jobs may be summarised as follows:

Contract price Costs incurred to end of financial year Costs estimated for next financial year Work certified by surveyor and invoiced to customer Cash paid by customer

£18m 9m 6m

lOrn 8m

The balance represents an amount held back by customer to meet contingencies which may arise between date of work being handed over and a specified period after work completed.

A

B

c

Profit calculations:

Costs to date Work invoiced

Total costs Costs to date

Profit

Total profit (Selling price £18 m - Costs £15m)

Profit 9/15ths =

Work certified Work paid for, i.e. 80%

Profit 80% of £3 m

£9m lOrn

£15m 9m

3m

£10m 8m

£1m

£1.8m

£2.4m

The profits vary between £1 m and £2.4 m. The account for the job will have incurred cost of £9 m, whilst cash received from the customer is only £8 m. Dividend would have to be limited to other available funds.


Accounting procedure for Contract Job Costing

Prepare an account to which all costs of the contract will be charged. At the end of the financial year the value of stores, plant and work in progress on the site will be valued and credited to the contract. Any completed work which has been certified by the architect will be similarly credited to the contract, and an account opened in the name of the contractee, to which the value of the work certified will be charged.

The profit to date on the contract will be calculated and the necessary proportion taken to the Profit and Loss Account, the balance being treated as a reserve against possible future losses.

A construction company undertakes two contracts and the following are the details at the end of the financial year.

Value of Contract Date commenced Work certified Materials delivered

to site by suppliers from own store Materials returned to suppliers Materials sold as scrap (cost £2,500) Cost of Plant delivered to site Wages Site Expenses Work not certified at year end Stores on site at year end Plant as valued Retention

350 £400,000 1 Jan.

£200,000 60,000 10,500 4,000

20,000 69,000

6,000 12,000 4,500

13,000 10%

Contract No.

351 £200,000

1 Apr. £150,000

90,000 8,000

3,000 6,000

40,000 7,000 4,000 1,500 Nil 10%

Administration expenses £31 ,500 are to be apportioned to the contracts on a time basis.

After providing a reserve equal to the amount retained by the contractees the company provides a further 25% before taking credit for any profit.


Contract No. 350

Description: ........ . Value £400,000 Materials:

from suppliers from store

Plant at cost Wages

Site Expenses Administration Expenses

Profit to date To Reserve To Pand L.

Stores b/d Work in Progress b/d Plant b/d

Work Certified

Balance b/d

27,500 22,500

60,000 10,500 20,000 69,000

6,000 18,000

183,500

50,000

£233,500

Materials returned Stores on hand c/d Plant as valued c/d Work completed, not

certified c/d Work certified

4,500 Profit Reserve b/d 12,000 13,000

Contractee 200 ,000 Cash received

Balance c/d

£200,000

20,000

4,000 4,500

13,000

12,000 200,000

£233,500

27,500

180,000 20,000

£200,000

Profit to date £50,000, less retention of £20,000, gives £30,000 from which is deducted 25% £7,500 to give a profit of £22,500.


Contract No. 351

Description ....... . Value £200,000 Materials:

from suppliers from store

Plant at cost Wages Site Expenses Administration

Expenses

Profit on sale of materials

Reserve on retention money

Stores b/d Work in Progress

Work Certified

Balance b/d

90,000 8,000 6,000

40,000 7,000

13,500 164,500

500 165,000

15,000

£180,000

1,500 4,000

Materials sold - proceeds 3 ,000 Stores on hand c/d 1,500 Work completed not certified 4,000 Work certified 150,000

Loss to date to Profit and Loss

Profit reserve b/d

158,500

21,500

£180,000

15,000

Contractee 150 ,000 Cash received

Balance c/d

£150,000 15,000

135,000 15,000

f-150,000

The contract has incurred a loss to date of £6,500 to which must be added a reserve to cover the retention money of £15,000.

Any accrued charges outstanding at the end of the financial period must be included as part of the costs for the period under review, brought down on the contract and shown as current liabilities in the Balance Sheet. The balance on the contractee account must not be shown as a current asset; it may not be payable for a considerable time after the completion of the contract, but will be incorporated in the Work in Progress calculations:

No. 350 No. 351 Balance on Contract 12,000 4,000

as Work in Progress Balance due by Contractee 20,000 15,000

32,000 19,000 Less Reserve 27,500 15,000

Amount for Balance Sheet £4,500 £4,000

276 A Foundation in Busine,ss Accounting

Process Costing

This method of collecting costs arises where either (a) the material loses its identity in the course of production and in addition there is loss through evaporation, or (b) the job is such that more than one department may be involved in the fmal production and it is necessary that the costs of each department be identified, or (c) the item being produced is such that part-completed sections may be sold and it is therefore necessary to ascertain the cost at various stages in production.

The collection of costs operates in the same manner as for job costing - each process may be considered as a separate job. Materials are costed to process as required via the stores requisitions. Labour is charged in accordance with time cards. Overheads are charged on an agreed basis.

The major difference is that in process costing it is recognised that a loss in production is bound to arise and the cost of the loss is charged to saleable production, thus increasing the cost per unit.

Where standard losses can be set up, any difference between standard and actual loss is treated as a variance and charged to the Profit and Loss Account at the cost of production.

The system of process costing may be applied to brickmaking, chocolate manufacture, pottery, textiles, dairy products, paper making. Accounting for costs:

Units Material 1 ,000 Labour Overhead

1,000

Units Transfer from

Process I 1 ,000

Cost this process Material Labour Overhead

1,000

Process!

Costs Units Costs 250 Transfer to 750 Process II 1,000 2,500

1,500 (Unit cost= £2.50)

£2,500 1,000 £2,500

Process!!

Costs Units Costs Transfer to

2,500 Finished Goods 1,000 3,850

(Unit cost = £3.85, 300 Process cost £1.35) 700 350

£3,850 1,000 £3,850

If the product is saleable at the end of process I the producer has a cost on which to base his selling price.

Where production is lost, the cost is as follows:


Process I

Units Costs Units Costs Costs as 1,000 2,500 Production to 800 2,500 previously Process II

Loss 200

1,000 £2,500 1,000 £2,500

Process II

Units Costs Units Costs Trans:er from Process I Production 700 3,850

800 2,500 Loss 100 Costs this process 1,350

800 £3,850 800 ~.850

Where the loss or waste is recoverable and saleable as scrap, the proceeds will be used to reduce the cost of processing.

Assuming that waste from process I is saleable at SOp per unit and from process II at £1.10 per unit, the position is:

Process!

Units Costs Units Costs Costs 1,000 2,500 Scrap value of 200 100

units loss Production 800 2,400

1,000 £2,500 1,000 £2,500

Process II

Units Costs Units Costs From Scrap value of Process I 800 2,400 units lost 100 110 Costs this Production 700 3,640 process 1,350

800 £3,750 800 £3,750


Where a standard loss is anticipated and production is then more or less than standard position is:

Process!

Units Costs Units Costs Costs 1,000 2,500 Standard loss

20% at scrap value of SOp 200 100

Actual Produc-tion 750 2,250

Variance-Additional Loss 50 150

--1,000 £2,500 1,000 £2,500

Cost per unit £3 (£2,500 - 100 + 800) :. Cost of 750 saleable units £2,250

Cost of 50 lost units £150

The additional loss is a charge to Profit and Loss

Process II

Units Costs Units Costs From Standard loss 20% at Process I 750 2,250 scrap value of

£1.10 150 165 Costs this Actual process 1,350 production 660 3,778

750 3,600 Variance-

Additional production. 60 343

810 £3,943 810 £3,943

Costs £3,600 ... 165 = £3435

Production 750- 150 600 Cost per unit= £5.725

:. Cost of 660 saleable units @ £5.725 = £3,778

Where there is a variance due to additional loss in production the waste will be sold at the usual rate, the revenue being offset against cost of producing the additional waste.

Where the variance is due to additional production the quantity of scrap available for sale is reduced, the balance between actual and anticipated sale being written off to the variance account.

Process I Anticipated Sales:

200@ SOp Variance a/c

Process II Anticipated Sales:

1SO@ £1.10

Process I Cost of Production

Scrap Account Profit and Loss a/c


Scrap Account (Standard Loss)

100 2S

16S

£290

Actual Sales: 2SO@ SOp

Actual Sales: 90@ £1.10

Variance

Variance Account (Adverse) (Additional Losses in Production)

1SO

£1SO

Scrap Account Profit and Loss a/c

Variance Account (Favourable) (Additional Production)

66 277

£343

Process II Cost of Production

12S

99 66

£290

2S 12S

£1SO

343

£343

Under a system of process costing it is not essential that each process automatically follows the previous process. The product of each process may well be completed units which are placed in store or refrigeration and the finished products then combined, as in chocolate manufacture where a variety of fillings are produced. The cost of each is ascertained and an assortment of the various fillings used to make a complete box. The percentage of each type making up the complete assortment is calculated on a standard basis.

A confectionery or chocolate manufacturer may undertake a variety of processes and the final cost of an assortment consists of a selection from the various processes.

The milk is preserved and stored in bulk, a quantity of cocoa butter is subsequently added to make the chocolate for covering, whilst at the same time a quantity of base cream is manufactured. A variety of centres are also prepared, e.g. orange, cream, caramel, strawberry cream. The costs of the processes are then collected and apportioned over a selection in the required proportions.

Similarly, in the electrical industry a complete unit may consist of a variety of kits which have been assembled as required. The cost of the individual kit or process is then collected to ascertain final cost of a complete unit.


The basic difference between the two processes is the absence of work in progress in chocolate-making and a variety of partly assembled kits in electrical engineering. Both organisations use basic processes or kits and complete the product with the specialist section.

In the case of confectionery all varieties require an outer covering of chocolate but the centres vary whilst in television manufacture, for example, the variation is in size of tube and cabinet. Other components are standard.

The type of costing system used by both organisations could be referred to as process, jpb or batch. Each section of the complete operation is a separate process, the job consisting of the manufacture of a quantity of cream or a number of kits and the cost being ascertained when the process or batch is completed.

Computation of costs

Chocolate-making

Process 1. Preserved milk 14 per 100 lbs. 2. Chocolate-making _§_per 100 lbs.

Total to date 20 3. *Caramel centre J.Q.per 100 lbs.

Total to date 30 4. Amalgamate filling

and coating (Labour only) ~per 100 lbs.

Total of completed £32 per 100 lbs. units

*Note that the cost will vary according to the type of filling used.

Television manufacture

Kit 1. Speaker assembly 2. Power supply

3. Tube base

4. Control panel

5. Final assembly

2.70 1.20

7.50

2.50

50.10

£64.00

Cost is the total of all kits as each unit requires the same components. An adjustment is only necessary in so far as the s1ze of the umt 1s concerned.

The extent to which losses in production increase the final cost can be seen from brick production:

Bricks made 27m Material £1 per 1,000 Labour £5 per 1,000

Bricks placed in kiln 26m Material £39,000 Labour £104,000

Bricks drawn from kiln 25m Finished expenses £31,000 Bricks unsaleable 1m


Cost Statement

Process I - Making per 1000 Materials: Clay @ £1 per 1,000 27m 27000 £1 Labour 135,000 5 -

Cost of Producing 162,000 6 :. Cost of Waste

1/27th of £162,000 = £6,000 .23

Cost of Process I 26m 162,000 6.23 Process II - Firing

Material 39,000 1.50 Labour 104,000 4.00

Cost of Firing 305,000 11.73 :. Cost of Waste

1/26th of £305,000 = £11.330 .47

Cost of Processes I and II 25m 305,000 12.20

Process III - Finishing Costs 31,000 1.24

Cost of Producing 336,000 13.44 :. Cost of Waste

1/25th of £336,000 = £13,444 .56

Final Cost 24m £336,000 £14.00

If 27 m bricks had been produced the cost would have been £12.44 per 1 ,000 : £336,000

27,000

Where a process is continuous and it is not possible to cease production due, for example, to the time required to obtain the necessary temperature, a deci• sion must be made as to the method of valuing part-completed units, the work in progress, at the end of a fmancial period.

The problem arises from the fact that whilst materials for a given production at a standard rate are placed in the process and it is known how many completed units have been drawn out, so far as labour is concerned this has been employed in servicing all units and it is not possible to distinguish between time occupied on completed units and those partially completed. Similar considerations apply to the charging of overheads.

It is necessary, therefore, that a standard level of completion be adopted in respect of work in progress for each process, in order that labour and overheads can be apportioned to a specified number of complete units.


In period I work is commenced on 42,000 units and costs were: materials £10,500; labour £7,992; overheads £11,988.

During the period 30,000 units are transferred to process II and the remaining 12,000 units are 100% complete regarding materials but only 50% complete regarding labour and overheads.

Process 1 (Period 1)

Units Costs Ref. Materials 42,000 10,500 To Process II Overheads 7,992 A 30,000 24,150 Labour 11,988 Work in Progress

B 12,000 6,330

42,000 £30,480 42,000 £30,480

Materials will be applied evenly in respect of the 42,000 units either at commencement or during process, so that by the end of the period they are 100% complete. So far as Work in Progress is concerned these units are only partially completed and, due to the varying stages of completion, they are assumed to be, on average, 50% complete. The Work in Progress, therefore, represents 6,000 complete units in respect of Labour and Overheads.

Costs Units:

Finished Closing Work in Progress

Per Unit

Cost of complete units: Material Labour and

Overheads

Cost of Work in Progress: Material Labour and Overhead~

Calculations

Materials

£10,500

30,000

12,000 SO%

42,000

.25p

30,000@ .25

30,000@ .555

12,000@ .25

6,000@ .555

Labour and Total Overheads

£19,980 £30,480

30,000

6,000

36,000

.555

Ref. 7,500

16,650 24,150 A

3,000

3,330

6,330 B

£30,480


In period II costs incurred are: material for 30,000 units £7 ,SOO; labour £6,018; overheads £12,002. 28,000 units are completed.

Process/ (Period II)

Units Costs Ref. Units Costs Work in Transfer to Progress 12,000 Process II c 28,000 24,080

Material 3,000 Labour and

Overheads 3,330

6,330 Work in Progress D 14,000 7,770

This period: Material 30,000 7,SOO Labour 6,018 Overheads 12,002

42,000 £31,8SO 42,000 £31,8SO ---

The material for Work in Progress was added in period I. Material is added in this period for additional production.

Labour and Overheads is a charge for completing the opening Work in Progress, the manufacture of units commenced and completed in the period and the commencement of units uncompleted at the end of the period. It will therefore be necessary to calculate the number of units actually completed in the period:

Units transferred to Process II Add units half.completed at end

(SO% of 14,000)

Less units half completed at commencement (SO% of 12,000)

Units fully completed in period

28,000

7,000

3S,OOO

6,000

29,000


Calculations

Materials

Costs: Opening Work in Progress 3,000 Period charges 7,500

£10,500

Units: Opening Work in Progress 12,000 50% Period 30,000

42,000

Per unit .25p

Cost of completed units: Material 28,000@ .25p Labour and

Overheads 28,000@ 61p

Cost of Work in Progress: Material Labour and

Overheads

14,000@ .25p

7,000@ .61p

Labour and Overheads

3,330 18,020

£21,350

6,000 29,000

35,000

.61p

7,000

17,080

3,500

4,270

Total

6,330 25,520

£31,850

Ref.

24,080 c

7,770 D

£31,850

So far as process II is concerned, costs in period I will consist of cost of completed units transferred from process I together with any costs required in process II. The Work in Progress will be valued on the agreed basis.

Period I - Work continued on 30,000 units transferred from process I and additional costs are: material £6,000; labour £2,860; overheads £4,570.22,000 completed units were transferred to store and the Work in Progress was considered to be three-quarters complete.


Process II (Period I)

Units Costs Ref. Units Costs To

Transfer from Transfer to Process I 30,000 Store E 22,000 28,820 Material *7,500 Labour and Work in Overheads t16,650 Progress F 8,000 8,760

24,150 This process

Material *6,000 Labour t2,860 Overheads t4,570

30,000 £37,580 30,000 £37,580

Calculations

Material Labour and Total Overheads

Costs *£13,500 t£24,080 £37,580 Units:

Finished 22,000 22,000 Work in Progress 8,000 75% 6,000

30-,000 28,000

= .45p .86p

Cost of complete units: Ref. Materials 22,000@ .45p 9,900 Labour and

Overheads 22,000 @ .86p 18,920

28,820 E

Cost of Work in Progress: Material 8,000@ .45p 3,600 Labour and

Overheads 6,000@ .86p 5,160

8,760 F ---£37,580


Period II - Costs for process II are: materials for 28,000 units £5,600; labour £2,090; overheads £4,480. 26,000 units are completed.

Process// (Period//)

Units Costs Ref. Units Costs Opening Work Transfer to in Progress 8,000 Stock G 26,000 34,060

Material 3,600 Labour and Overheads 5,160

8,760 Work in Progress H 10,000 10,950

Units from Process I

Material 7,000 Labour and

Overheads 17,080

This period Material 5,600 Labour 2,090 Overheads 4,480

36,000 £45,010 36,000 £45,010

As for process I in period II, the material for Work in Progress in process II at commencement of period II was added during period I. The material introduced in period II is for additional production. The labour and overhead charge covers the cost of completing Work in Progress units commenced and completed in the period and units commenced but in Work in Progress at the end of the period.

Units completed in period are:

Units transferred to Stock Add units * complete at end

(75% of 10,000)

Less units * complete at commencement (75% of 8,000)

Units completed in period

26,000 7,500

33,500

6,000

27,500

Calculations

Costs Material

Opening Work in Progress Period charges

3,600 12,600

£16,200

Opening Work in Progress Period

:::

Cost of completed units:

8,000 75% 28,000

36,000

.45p

Material 26,000@ .45p Labour and Overhead 26,000 @ .86p

Cost of Work in Progress: Material 10,000@ .45p Labour and Overheads 7,500@ .86p


Labour Total Overhead

5,160 8,760 23,650 36,250

£28,810 £A.5,010 ---

6,000 27,500

33,500

.86p

Ref. 11,700

22,360 34,060 G

4,500

6,450 10,950 H

£45,010

Where a process results in joint or by-products, consideration will have to be given to the manner in which costs are allocated to the various products. Joint products cover, for example, the varying cuts of meat from a single animal or varying grades of oil from a single barrel. By-products cover the saleable commodity resulting from an initial product, e.g. wood shavings as a result of cutting up timber.

Management may know the cost of a single animal - a decision has to be made as to how the cost is to be apportioned over the various saleable products.

The basic problem is: Does the revenue from the sale of the joint products exceed the total costs? If any additional costs are incurred in processing the joint product, is this covered by the revenue from the additional product?

The total costs of a process can be apportioned to the various products either on the basis of percentage of total weight of the individual products or on the basis of percentage of total sales revenue of each product.

Questions

11.1 From the following information draw up a statement to show (1) prime cost, (2) factory cost and (3) total cost, of one unit of each of products X and Y.


Departmental overheads are to be apportioned between products on the basis of Direct Wages. Selling, Distributive and Administrative expenses are to be apportioned on the basis of factory costs.

Direct Labour Direct Materials Direct Expenses

Departmental Overheads(£) Indirect Labour Indirect Materials Indirect Expenses

X(£) 8,000 4,000 2,000

Selling, Distribution arid Admin. Overheads Units produced X - 1 ,000

Production details

4,800 3,600 1,200 7,600

y (£) 7,200 2,400 4,800

y -1,200

Calculate the selling price of (a) a unit of X and (b) a unit of Y, in order that a profit of one-seventh of the selling price is achieved in each case.

11.2 From the information given below prepare the accounts for jobs in progress at 1 January. Write up the cost cards for the week and close off the completed jobs. Show the entries in the Work in Progress Account.

Job Nos. 656 and 836 were invoiced to customers at £550 and £330, respectively:

Balances at 1 Jan: Materials Labour

Job No. 631 35.90 8.70 656 185.50 57.80 793 40.50 14.90 819 12.35 2.25· 836 120.00 26.40

Material Issues during week: Component Qty. Price

Job No. 656 1379 100 15p each. 793 1572 15 £1.15p each 656 1935 50 90p each 836 1275 80 85p each

Labour hours worked in week: Job No.

Employee Hrs. Rate 631 656 793 819 836 Black 40 60p 10 4 6 12 8 Smith 36 80p 3 6 15 4 8 White 40 75p 6 8 5 5 16


Overheads are charged to jobs on completion at the rate of 120% of direct wages cost.

11.3 Special Containers Ltd designs and manufactures special-purpose containers for various industries. The company has been requested to submit quotations for supplying a specially designed container, to which the following data relate.

Design and development costs are estimated as follows:

Design/Development Engineers' time- 11 hrs.@ £3 per hr. Draughtsman's time- 12 hrs.@ £1 per hr. Materials £18 Engineering Machine Shop time- 1S hrs.@ £3.60 per hr. Project supervision £3 S General Overhead allocation £40.

The production machine which will be used for the manufacture of the containers requires 12 hours of an engineer's time (£1.80 per hour) for setting up and has an output of ten containers per hour; it will be used exclusively on the production of this type of container for eight hours per day, five days per week, until the order is completed.

Operatives are paid an hourly rate of £0.80 and overhead is absorbed by the application .of an hourly rate of £1.2S. The direct material cost per container is £0.20.

It is the company's practice to provide for a profit of 12~% on design and development costs, and 2S% on production costs.

Calculate the price to be quoted per 100 containers for the supply of (a) 2,000 containers, and (b) 4,000 containers.

11.4 From the following particulars you are required to prepare a Process Cost Statement showing: (a) the cost of input material in total and per lb, and (b) the manufactured cost of final output in total and per unit.

Direct Materials: In stock 1 July

A 1,300 lbs.@ .2Sp per lb. B 1 ,SOO lbs. @ .20p per lb. C 1 ,17S lbs.@ .lSp perlb.

Direct Labour:

Department 1 2 3

Purchased during year

14,000 lbs@ .26p per lb. 16,SOO lbs.@ .22Sp per lb. 12,SOO lbs@ .17p per lb.

10,000 hrs.@ SOp per hr. 12,000 hrs.@ SSp per hr. 9,000 hrs. @47.Sp per hr.

In stock 30 June

1,4SO lbs. 1,600 lbs. 1,300 lbs.


Production Overhead Absorption Rates:

Department I 40p per hr. 2 35p per hr. 3 30p per hr.

The quantities used produce an output of 4,250 units. Units scrapped were sold for £I0.75.

II.5 A company manufactures a standard unit which passes through three processes. From the following information prepare the Process Accounts.

Process! Process 2 Process 3

Units entering process 6,000 5,500 5,450 Materials consumed £3,000 £800 £500 Labour consumed £I,500 £I,OOO £I,OOO Overhead £755 £465 £57 I Output - units 5,600 5,000 4,800

The units purchased for process I cost £7,000. In calculating standard process cost, normal wastages in process, based upon

the number of units introduced, is taken as follows: process I, 5%; process 2, 10%; process 3, 10%.

Value of scrap is: process I, £855; process 2, £890;process 3,£981. There was no Work in Progress at any stage.

CHAPTER 12

Standard Costing

This is a method of costing which provides management with information on practically a day-to-day basis and overcomes the problems of historical costing whereby the results of a job are not known until completion. Although an investigation might be carried out into the reasons for the failure to meet the original estimate, such an investigation is too late to be of value so far as the completed job is concerned.

The system of historical costing may also lead to uneconomic prices being quoted, as the cost of one inefficient job may well form the basis for an estimate of a similar job in the future. There is also no basis on which to locate faults in the management system, e.g. inefficient buying of materials, inefficient use of personnel, inefficient use of factory facilities.

It is not denied that standard costing involves nothing more than the preparation of a series of detailed estimates but such estimates are prepared in a manner which enables management to determine differences, or variances as they are termed, prior to commencement of, and during the course of, production. Action can be taken to eliminate the fault at the point of occurrence and not on completion of the job. Losses can be minimised.

Standard costing provides the following: (1) distinction in increased costs of material as between market fluctuations and excessive factory usage; (2) distinction in changes in labour costs as between movements in rates and efficiency of labour; (3) distinction in changes in administration costs as between additional costs and efficient use of factory facilities.

The system also provides a control on departments. For example, the purchasing manager is given standards within which to purchase materials; the production manager is given standards within which to use materials; the personnel manager is given standards within which to remunerate personnel; the works foreman is given standards by which personnel should complete a task; departmental heads are given a budget within which their expenditure should be contained; factory departments are set production standards required to recover the anticipated overheads.

A system of standard costing leads to economies resulting from the integration of accounting records and eliminates the necessity for reconciliation of the costing and financial records.

The system may be introduced in stages, e.g. material control, labour efficiency, overheads. It serves the following purposes:


(1) Facilitates control by management. (2) Segregates temporary rises or falls in costs and sales. (3) Provides management with regular statements of productions. (4) Enables authority to be delegated, costs being allocated on a departmen

tal basis. (5) No necessity to provide terminal costs.

A standard is a predetermined figure based on experience and estimates and takes into account materials, wages, variable expenses and fixed expenses.

Standards may be varied in the light of history but this should not be done too frequently.

Management will be able to monitor whether (a) the best use is being made of materials; (b) the flow of work is satisfactory; (c) the plant is used efficiently. Management will also be able to ensure (d) that idle time is controlled; (e) that changes in production do not obscure price changes; (f) that costs are not distorted by production changes.

Setting of Standards

Materials -price, type and quantity. Engineers, designers and chemists decide the most efficient type, based on durability, availability and market prices. What quantity should be used, making a suitable allowance for waste? What price should be paid, making allowance for market variations? (In chocolate manufacture a recipe will be decided upon which will be the standard mix of ingredients.)

Labour - rate, grade and time. Work study will decide the form of labour after examination of the availability, facilities and current rates. What rate should be paid, allowing for wage negotiations? What time should be allowed, taking into account accepted losses?

Expenditure - costs and recovery. Departments, in conjunction with management, will prepare detailed budgets of future costs based on production and sales targets. What production is required to meet costs? What is the proportion of costs per unit?

Terminology

Standard: the predetermined basis, e.g. price to be paid, production required per hour.

Actual: the result obtained, e.g. price actually paid, production actually obtained.

Variance: the difference between the standard required and the actual result.

Types of Variance and Causes

Material Price: the difference between the standard price and the actual price, for a unit of the commodity.

Material Usage: the difference between standard quantity for a given production and the actual quantity.

Standard Costing 293

Labour Rate: the difference between the standard rate for a unit of production and the actual rate.

Labour Efficiency: the difference between the standard time for a unit of production and the actual time.

Overhead Expenditure: the difference between the budgeted expenditure and the actual expenditure.

Overhead Volume: the difference between the budgeted recovery and the actual recovery on the actual production.

Price variance arises from: (1) use of substitutes; (2) purchase of small quantities; (3) purchase of bulk quantities, giving rise to discounts; (4) market price changes.

Usage variance arises from: (1) use of substitutes, leading to faulty workmanship; (2) inefficient control on the factory floor, giving rise to excessive waste; (3) use of improved quality material, giving more output.

Rate variance arises from: (1) changes in type of labour, e.g. skilled to semiskilled; (2) operation of wage agreements.

Efficiency variances arises from: (1) improved use of factory plant; (2) use of substitutes; (3) changes in type of labour; ( 4) inefficient control of facilities.

Expenditure variance arises from: (I) services utilised not anticipated; (2) elimination of unnecessary services; (3) changes in costs.

Volume variance arises from: (1) factory efficiency or inefficiency; (2) changes in production methods, resulting in time difference; (3) shortfall in expected throughput of work, e.g. reduction of demand.

Variance Calculations

Material Price ) Labour Rate Overhead Expenditure Material Usage } Labour Efficiency Overhead Volume

Formula: Actual quantity bought at actual price compared with actual quantity at standard price.

Formula: Actual quantity used at standard price compared with standard quantity used at standard price.

Sub-divisions of volume variance

Capacity: Budgeted hours for budgeted output compared with actual hours used for actual output.

Efficiency: standard hours for actual output compared with actual hours for actual output.


Accounting for Variances

Materials - Price

The difference between standard price and actual price:

Standard Price £80 per ton Standard Price £80 per ton Actual Price £79 per ton Actual Price £83 per ton

Variance £1 per ton This is a favourable variance as a lower price has been paid than was anticipated

Variance £3 per ton This is an adverse variance as a higher price was paid than was anticipated

If 100 tons had been purchased at the two prices, entries would be:

Stores Stores

100 tons@ £80 8,000 I 100 @ £80 8,ooo 1

Supplier Supplier

1100 @ £79 7,900 1100@ £83 8,300

Material Price Variance Material Price Variance

lwo @£1 100 100 @£3 300 1

The variance is segregated on receipt of supplier's invoice, although examination questions always require the calculation at the end of an accounting period in order to demonstrate the breakdown of the total variance into price and usage.

Combining the entries given would show:

Stores Creditors

100 @£80 8,000 100 @£79 7,900 100 @£80 8,000 100 @£83 8,300

16,000 16,200

Material Price Variance

100 tons@ £3 300 100 tons@ £1 100 Profit and Loss 200

£300 £300

An investigation can be carried out prior to issue of materials to job as to the reason for variance.


Material Usage

The difference between standard quantity and actual quantity.

Favourable variance

Standard Quantity Actual Quantity

Variance

1 ton

* Less material used than anticipated

Adverse variance

Standard Quantity Actual Quantity

1 ton It t

More material used than anticipated

If the material for 40 units is withdrawn from Stores:

Stores

Returns 40 tons @ £80 3,200

10 tons@ 80 800 (40 units@~ ton)

Work in Progress

40 units @80 3,200 1

Material Usage Variance

110 tons @ £80 800

40 units @80

Stores

40 tons@ £80 3,200 5 tons@ £80 (40 400 units@ t ton)

Work in Progress

3,200 I Material Usage Variance

5 tons @£80 400 1

The introduction of standards leads to the preparation of preprinted stores requisitions, indicating the standard quantities for given levels of production. The materials not required will be returned to stores; an additional requisition will be required to draw the extra material from stores.

Management will be aware when stores are withdrawn and the standard has been exceeded, and the necessary investigation may then be carried out.

Combining the entries would show:

Stores Work in Progress

Material Usage 40 tons 40 units Variance @£80 3,200 @£80 3,200 10 tons @ £80 800 40 tons 40 units

@£80 3,200 @£80 3,200 Material Usage Variance 5 tons @£80 400



Stores, 5 tons@ £80 Profit and Loss a/c

400 Stores, 10 tons@ £80 800 400

£800 £800

The work in progress represents the standard cost of materials for 80 units, 6,400 (1 ton per unit = 80 tons @ £80 per ton). If more or less units are produced a further variance will arise, representing the efficiency of production.

Labour rate

The difference between standard cost oflabour per hour and the actual cost.

Favourable variance

Standard Rate per hr. Actual Rate per hr.

£2.00 £1.80

Variance 0.20

If 300 hours are paid for the entries will be as follows:

Bank

Labour Rate Variance 300 hrs.

540

@20p 60

Bank

1300 hrs. @£1.80 540

Wages

Labour Rate Variance

I Wages 60

The £600 balance on Wages repesents 300 actual hours at the standard rate of£2.

Adverse variance

Standard Rate per hr. Actual Rate per hr.

£2.00 £2.30

0.30

If 360 hours are paid for the entries will be as follows:

Bank

1360 hrs. @ £2.30 828

Wages

Bank 828 Labour Rate Variance 360 hrs. @30p 108

Labour Rate Variance

Wages 108 I The £720 balance on Wages represents 360 actual hours at the standard rate of£2.

Standard Costing 29 7

Labour efficiency

The difference between standard time per unit and actual time.

Favourable variance

Standard time per unit Actual time per unit

Variance

8 hrs. 71/z

Yz hr.

Adverse variance

Standard time per unit Actual time per unit

8 hrs. 9

1 hr.

The 40 units being produced at 8 hours would give the following:

Wages Wages

b/f 600 Work in b/f 720 Work in Progress Progress

Labour 320 hrs. 320 hrs. Efficiency @£2 640 @£2 640 Variance 40 Labour

Efficiency Variance 80

Work in Progress Work in Progress

40 units 40 units @ £16 640 @ £16 640 (8 hrs. @£2)

Labour Efficiency Variance Labour Efficiency Variance

Wages 40 Wages 80 (20 hrs. (40 hrs. @£2) @£2)

Overheads

Variable Expenditure Variance

The difference between standard cost and actual cost. These costs include items which will not be incurred if the product is not produced or sold, e.g. royalty, commission and packaging. There may, however, be price changes not envisaged when the standard was set.

Favourable variance

Standard cost per unit Actual cost per unit

Variance

£1 £0.80

£0.20

Adverse variance

Standard cost per unit Actual cost per unit

£1 £1.15

£0.15


The 40 units being produced give rise to the following entries:

Variable Overheads

40 units 40 @£1

Supplier

I Charge 40 @80p

Expenditure Variance

I 40 units @20p

8

Work in Progress

40 units @£1

Overhead Recovery

I Work in Progress 40

32

Variable Overheads

40 units 40 @£1

Supplier

I Charge 46 40@ £1.15


40 units @ 15p

40 units @£1

Work in Progress

401

Overhead Recovery

I Work in Progress 40

Note: Overheads have been entered at standard charge in the expense account. The variance was calculated on receipt of invoice.

Fixed Overheads

These can only be calculated on a unit basis as a result of estimating total expenditure and total production. Movements in either will affect the amount of overheads recovered.


Favourable

Estimated expenditure Actual expenditure

Variance

£200 170

£30

Fixed Overheads

Period Charge

200 I

Adverse

Estimated expenditure Actual expenditure

£400 440

£40

Fixed Overheads

Period Charge

400 1

Creditors

I Charge 170


30

Volume variance


Creditors

I Charge 440


The difference between overhead recovery on actual production at the standard rate and recovery on budgeted production

Favourable variance

Budgeted production 25 units Actual production 40 units

Variance 15 units

Budgeted overheads £200 Budgeted overheads

per unit £8 (£200 + 25 units)

Work in Progress

40 units @£8 320

Overhead Recovery

I Workin Progress 320

Note that Fixed Overheads were charged with £200. There has been additional recovery of £120 represented by the 15 units@ £8.

Adverse variance

Budgeted production 50 units Actual production 40 units

Variance 10 units

Budgeted overheads £400 Budgeted overheads

per unit £8 (£400 +50 units)

Work in Progress

40 units @£8 320

Overhead Recovery

I Workin Progress 320

Note that Fixed Overheads were charged with £400. There has been a loss in recovery of £80 represented by 10 units@ £8.


No accounting entries are required for volume variance. Final entries are as follows:

Work in Progress

Materials, 80 units@ £80 Labour, 80 units @ £16 Variable Overheads,

6,400 I ,280

Transfer to Finished Goods 8,400

80 units (al £1 Fixed Overheads,

80 units@ £8

80

640

£8,400 £8,400

Finished Goods

80 units@ £105 8,400

Sales variances

These arise either as a result of a change in selling price or sales volume.

Price variances

The selling price is more or less than the standard selling price.

Favourable variance

Standard selling price Actual selling price

Variance

£140 150

£10

Adverse variance

Standard Selling price Actual selling price

Variance

£140 120

£20

If sales are 30 units, entries are as follows:

30 units @£150

Sales

30 units at standard selling price of £140 4,200

Debtors

4,500 1

Sales Price Variance

I 30 units @ £10 300

30 units @ £120

Sales

30 units at standard selling price of £140 4,200

Debtors

3,600 I Sales Price Variance

30 units I @ £20 600


Volume variance

The quantity sold is more or less than the standard.

Favourable variance

Budgeted sales Actual sales

Variance

Sales

Standard Sales 30 units

30 units 40 units

10 units

@£140 4,200

Debtors

40 units @ £140 5,600

Volume Variance

110 units @ £140 1,400

Adverse variance


40 units 25 units

Variance

25 units @ £140

15 units @£140

15 units

Sales

Standard Sales 40 units @ £140 5,600

Debtors

3,500 I

Volume Variance

2,100 I Both the price change and volume change affect the budgeted profit in that

the increase in price represents additional profit, a price reduction giving rise to a loss of profit.

Additional sales give rise to additional profit, the difference between selling price and cost of the additional sales, a reduction in volume leading to a fall in profit:

Budgeted sales, 30 units@ £140 Standard costs, 30 units@ £105

Budgeted profit, 30 units@ £35

Actual sales, 20 units@ £150 Standard costs, 20 units@ £105

Actual profit, 20 units@ £45

Total Variance

Price variance, 20 units@ £10 Volume variance, 10 units@ £35

4,200 3,150

£1,050

3,000 2,100

200 Fav. 350 Adv.

£150 Adv.

900

£150


On the basis of information presented, with budgeted sales of 70 units @ £140 and actual sales of 40 units@ £150 and 25 units@ £120, results would be presented in a report: Budgeted sales 70@ £140 Standard cost 70 @ £105

Budgeted profit

Variances

Sales price

Volume

Cost variances

Material price usage

Labour rate efficiency

Variable overheads

Expenditure

Fixed overheads

Expenditure Volume

Actual Profit

40@£10 25@ £20

5 @£35

Fav. 400

400

400

2

40

442

9,800 7,350

Adv.

500 175

675

200

48 40

10

298

2,450

275

£2,175

144 Fav.

£2,319

The report prepared, indicating the variances, will outline the reasons for these in order that management will be in a postion to take the necessary corrective action.

The following information relates to a process of a company employing a system of standard costing: The financial year is divided into 12 periods. (1) Calculate the material cost variances, given:

Materials specified- 100 lbs.% in. Zinc Rod per 100 units Price specified - 20p per lb. Material issued against production order for 2,000 units - 24,000 lbs. at 17p per lb. Actual output - 1 ,800 units

(2) Calculate the labour cost variance, given: Standard time- 25 hrs. per 100 units Standard wage rate - 40p per hr. Actual wages paid - 480 hrs. at 43p per hr. Actual output - 1,800 units

(3) Calculate the variable overhead variance, given: Budgeted variable overhead for year- £2,400 Budgeted output for year- 24,000 units Budgeted rate per unit - 1 Op Actual variable overhead - £200 Actual output - 1,800 units

(4) Calculate the fixed overhead variance, given: Budgeted fixed overheads for year- £6,000 Budgeted output - 24,000 units Standard time per unit - 15 minutes Actual hours worked and paid for - 480 Actual fixed overhead - £530 Actual output - 1,800 units


(5) Using the information given is sections (1) - (4), together with the following additional information, prepare a statement suitable for presentation to management, reconciling the budgeted profit with the actual profit: Standard selling price - £1 per unit Budgeted sales - 2 ,000 units Actual sales - 1,800 units at £1.05 per unit.

Accounting Statement

Budget, 2,000 units Actual, 1,800 units

Standard costs Per unit Total Std. Costs Actual Costs

Material, llb.@ 20p 20p 400 360 2,000 lbs. 340.00

@ 17 Labour, ~hr. @40p lOp 200 180 480 hrs. 206.40

@43 Overheads

Variable @lOp lOp 200 180 200.00 £2,400 units 24,000 Fixed @25p 25p 500 450 530.00 £6 ,OOO units 24,000

65p 1,300 1,170 1,276.40 Selling price £1.00 2,000 1,800 Actual sales 1,890.00

Budgeted profit --"Jsp £700 Std. profit £630 Actual profit £613.60


Variances

Budgeted profit Actual profit


Standard profit on actual sales

Actual profit on actual sales

Standard costs of actual production

Actual costs of actual production

Cost Variances, Ref. (i)

Material:

700 613.60

2,000.00 1,890.00

630.00

613.60

1,170.00

1,276.40

2,000 lbs.@ 3p (Std. 20p; Act. 17p)

Ref.

86.40 Adv. (ii)

110.00 Adv. (iii)

16.40 Adv. (iv)

106.40 Adv. (i)

Price Usage 200 lbs.@ 20p (Std. 1,800 lbs; Act. 2,000)

60 F 40A 20 F

Labour: Rate 480 hrs.@ 3p (Std. 40p; Act. 43p) Efficiency

30 hrs. @ 40p (Std. 450 hrs.; Act. 480)

Overheads - Variable

Expenditure (Std. £180; Act. £200) -Fixed

Expenditure (Budgeted £500*; Act. 530) Volume (Budgeted £500; Act. 450t)

Total Variance

Note: Production 1 ,800 units Variable cost lOp per unit:. Std. £180 *Fixed cost= £6,000 = £500 per period

12 periods

14.40 A

12.00 A 26.40 A

30.00 A 50.00 A

20.00 A

80.00 A

£106.40 A

tFixed overheads only recovered on production: 1,800 units@ 25p.


Volume variance reconciliation Capacity: Budgeted hours 500

Actual hours 480

20 hrs. @ £1 £20 A (Fixed overheads 25p per unit, 4 units per hour= £1 per hour)

Efficiency: Standard hours for output 450 Actual hours 480

30 hrs. @ £1 £30 A

Total Volume Variance £50 A

Capacity variance represents loss of time due to idle time or machine breakdown not budgeted for and is equivalent to 80 units (4 units per hour). Efficiency variance represents loss due to inefficient working. This is equivalent to 120 units:

Standard output for time taken ( 480 hours @ 4 units per hour) 1 !}20 Actual output 1 ,800

120 units

Cost Variances

Profit Variance, Ref. (ii)

Price, 1 ,800 @ Sp (Std. £1; Act. £1.05) Volume, 200@ 35p (Std. £1; Std. Cost 65p)

Variance between budgeted and actual profit

Sales Variance, Ref. (iii)

Price, 1,800@ Sp Volume 200 @ £1

Cost variances

Selling price variance

90 F 70 A

90 F 200A

Variance between standard profit and actual profit on actual sales Ref. (iv)

106.40

20.00 F

£86.40 A

£110.00 A

106.40 A

90.00 F

£16.40 A


The reconciliation of profit would be presented as follows:

Budgeted Profit

Profit - Sales price Sales volume

Costs - Material price Material usage Labour rate efficiency

Overheads- Variable expenditure Fixed expenditure Volume

Actual Profit

Alternative presentation:

Budgeted Sales

Sales - price Volume

Actual sales Standard cost of sales (1 ,800 @ 65p)

Standard profit on actual sales Cost variances (as detailed above)

Actual Profit

Variances

Fav. 90

60

£150

Adv.

70

40 14.40 12.00 20.00 30.00 50.00

£236.40

Variances

Fav. 90

Adv.

200

700.00

86.40 A

£613.60

2,000

110

1,890 1,170

720 106.40

£613.60

A company manufactures a product with a sales forecast of 160,000 units. The following standard costs have been agreed:

Material X 4lbs.@ lOp per lb. 40p Y 2lbs.@ 08p perlb. 16p

Labour 1 ~ hrs.@ £2 per hr. 3.00 Variable overhead 04p Fixed overhead £72,000 45p

160,000 units

£4.05


Note that standards are arrived at as follows: Materials per specification on a unit basis Labour per work study on a unit basis Variable overheads at rate agreed on a unit basis

The above will remain the unit standards and will move in total in relation to production.

Fixed overheads per unit are arrived at on the basis of:

Total estimated expenses _ . . Tota.I estimated production- Ftxed overheads per urut

The total cost may vary irrespective of production levels and will affect unit cost.

The financial year is divided into 10 periods. Actual results for period 1 were:

Production 17,000 units Materials X 70,000 lbs. £6,300 Y 31,000 lbs. £3,350 Labour 27,000 hrs. £48,600 Variable overheads £850 Fixed overheads £6,600

Note standard requirements for production: Material X 17,000 units@ 4lbs. 68,000 lbs.

Y 17,000 units @ 2 lbs. 34,000 lbs. Labour 17,000 units@ 1 ~ hrs. 25,500 hrs. Variable overheads

17,000 units @ 04p £680

Variable overheads will show an expenditure variance only, as by their nature a charge will only be made when unit is sold. This was calculated on a unit basis as agreed between parties concerned.

Fixed overheads, however, are calculated on the basis of estimated expenses in relation to estimated production. Any change in volume will affect overheads recovered.

There is no necessity to calculate per lb. or per hr. costs to arrive at price variances.

Calculations based on 17,000 units Standard Actual Total costs costs variances

Materials X @ 4 lbs. 68,000 lbs. 70,000 lbs. 2,000 lbs. A Y @2lbs. 34,000 lbs. 31,000 lbs. 3,000 lbs. F

Labour@ 1 ~ hrs. 25,500 hrs. 27,000 hrs. 1,500 hrs. F

Materials X @ 40p per unit 6,800 6,300 500 F Y@ 16p per unit 2,720 3,350 630 A

Labour @ £3 per unit 51,000 48,600 2,400 F Variable overheads@ 4p per unit 680 850 170 A

Fixed overheads@ 45p per unit 7,650 6,600 1,050 F

£68,850 £65,700 £ 3,150 F


Reconciliation of Variances

Materials - Price X Standard 70,000 lbs.@ lOp

Actual 70,000 lbs.

Y Standard 31 ,000 lbs. @ 8p Actual 31 ,000

-Usage X 2,000 lbs.@ lOp (Std. price) Y 3,000 lbs.@ 8p (Std. price)

7,000 6,300

2,480 3,350

700 F

870 A

200A 240 F

The net variance of £130 can be summarised: X price 700

usage 200 500

Y price 870 usage 240 630

£130

Labour - Rate Standard 27,000 hrs.@ £2 54,000 Actual 27,000 hrs. 48,600 5,400 F

- Efficiency 1 ,500 hrs.@ £2 (Std. rate) 3,000 A

Variable overheads -Price

Standard 17,000 @ 4p 680 Actual 17,000 850

Fixed overheads - Expenditure

Budgeted for period 7,200 Actual for period 6,600 600 F

-Volume

Budgeted recovery for period 7,200 (16,000 units@ 45p) Standard recovery for period 7,650 450 F (17 ,000 units@ 45p)

Total Variance

170 A

40 F

£130A

2,400 F

170 A

1,050 F

£3,150 F


Capacity Variance: Budgeted Hours Variance(£)

3,000 hrs. for Budgeted Output 24,000 hrs. (16,000 units @ 1 ~ hrs)

Actual Hours for Output 27,000 (Represents 18,000 units)

@ 30p 900 F (2000 units @45p)

Overhead could have been recovered or an additional 2,000 units, in time, used.

Efficiency Variance: Standard Time Actual Time Variance(£) for actual output for output 25,500 hrs. 27,000 hrs. 1,500 hrs. (17,000units@ (18,000 @30p 450A B~ hrs) units)

Overhead was only recovered on 17,000 units -it should have been recovered on 18,000 units in the time used. A loss of overhead on 1,000 units.

Volume Variance £450 F

Note: Overheads were 45p per unit -at 1 ~ hrs. per unit this represents 30p per hr.

Budgeted variable overheads were Budgeted fixed overheads were

Budgeted overheads Actual overheads

Fxpenditure variance

Budgeted recovery F.O. was (16,000 Ca145p) Actual recovery F .0. was (17 ,000 (a) 45p)

Volume variance

Total varia nee

£680 £7,200

7,880 7,450

£7,200 7,650

430F

450F

£880F

The Profit and Loss Account was charged with actual overheads £7,450 and credited with overheads recovered £8,330, an over-recovery of £880.


Std Cost X (a) Std Cost Y (b) Usage VarY

Stores 7,000 2,480

240

Std Issue X)WIP 6,800 Std Issue Y 2,720 Usage Var X 200


Creditors Act Cost X (a) 6,300 Act Cost Y (b) 3,350

9,650 Act Var Costs 850 Act Fixed Costs6,600

£17,100

Material Price Variance

2,000 X@ lOp 200 3,000 Y@ 8p 240 31,000 y (b) 870 70,000 X (a) P & L a/c

700 170 P & L A/c 40

£240 £870 £870

Wages Control Wages Rate Variance

Cash Act Std Cost @ £2 54,000 P & L 27,000 hrs @ 20p 27,000 hrs 48,600

Rate Variance 5,400

£54,000 £54,000

Direct Wages

Std Cost of Act hrs

54,000 Std Cost } 51,000 of Std hrs WIP 3 ,000 EffVar ---

£54,000 £54,000

Work in Progress Std Mats

17,000 Units 9,520 Std Wages

25,500 hrs 51,000 Var O'Hds

17,000 Units 680 Fixed O'Hds

17,000 Units 7,650

Finished Goods 17,000 Units

@£4.05 68,850

£5 .400 £5,400

Wages Efficiency Variance

1,500 hrs @£2

P&L

Overheads (various)

Variable-Act 850 P & L 7,450 Fixed-Act 6,600

£7,450 £7,450

Overhead Recovery

P & L 8,330 W.I.P. Var. O'Hds 680 Fixed O'Hds 7,650

£8,330 £8,330


Standard Costing Mix

Where a product requires a variety of materials in predetermined proportions, e.g. chocolate manufacture, it may be necessary to vary the mix due to seasonal fluctuations of a material, e.g. fresh milk when powdered milk must be used. These changes will give rise to more or less output and also affect the standard proportions of the various materials. It will become necessary to calculate, apart from the usual price and usage variances, the extent to which the usage variance was caused by the change of mix and the change in yield.

Assume that a product requires materials as follows: A- 50 lbs@ 25p per lb.; B- 20 lbs.@ 20p per lb; C- 30 lbs.@ SOp per lb. and that it is intended to produce 100 batches. Standard loss is 10% which has no scrap value.

Actual results were: Materials, A - 5,200 lbs.@ 27!hp; B- 2,075@ 20p; C- 3,200 @48p. Production -9,063lbs.

Calculate the following variances: cost, price, usage, mix, yield. (1) Set up standards based on actual output, i.e. original standard:

5,000 + 2,000 + 3,000 = 10,000 less 10% = 9,000 Actual Production 9,063

Therefore Standard quantities are:

9 •063 X 5 000 = 5 035 9•063 X 2 000 = 2 014 9•063 X 3 000 = 3 021 9,000 ' ' 9,000 ' ' 9,000 ' ' on the basis that increased output gives rise to increased standard use.

(2) Cost the revised standard quantities at the standard prices and compare with actual cost after allowing for actual loss in production (total variance).

(3) Calculate the price variance in the usual manner, i.e. actual quantity at the difference between standard and actual price.

(4) Usage variance - the difference between revised standard and actual usage at standard price. This variance has come about partly as a result of change in the mix and loss or increase in yield.

(5) Mix variance -original standard quantity and actual quantity at standard price.

(6) Yield - the difference between standard and actual yield at standard price.

Standard cost Standard cost Actual cost 100 batches (revised)

lbs. lbs. lbs. A 5,000@ 25p 1,250 5,035@ 25p 1,258.75 5,200@ 27!hp 1,430 B 2,000@ 20p 400 2,014 @20p 402.80 2,070@ 20p 414 C 3,000@ SOp 1,500 3,021@ SOp 1,510.50 3,200 @48p 1,536

--10,000 3,150 10,070 3,172.05 10,470 3,380

1,000 10% 1,007 10% 1,047 10% 360*

9,000 £3,150 9,063 £3,172.05 9,063 £3,380

= 35p per lb.

* Additional Loss


Total cost Variance: Standard £3,172.05 Actual 3,380.00

£207.9 5 Adv. Material A c Price Variance:

Standard 25p SOp Actual 27*p 48p

2* Adv. 3Fav.

A 5,200 @2*p £130A c 3,200@ 2p £64 F 66.00 Adv.

Usage Variance: A B c lbs. lbs. lbs.

Standard 5,035 2,014 3,021 Actual 5,200 2,070 3,200

165 A 56 A 179 A

A 165lbs.@25p £41.25 Adv. B 56lbs. @20p 11.20 Adv. C 179lbs.@ SOp 89.50 Adv.

141.95 Adv.

£207.95

Mix Variance: A B c lbs. lbs. lbs.

Original Standard 5,000 2,000 3,000 Actual 5,200 2,070 3,200

200A 70A 200A

A 200 lbs. @ 25p £50 Adv. B 70 lbs.@ 20p 14 Adv. C 200 lbs. @ SOp 100 Adv.

164.00 Adv.

Yield: Standard 9,000 lbs. Actual 9,063

~Fav.@35p 22.05 Fav.

£141.95 Adv.


Questions

I2.1 Distinguish clearly between wages rate variance and labour efficiency variance by defining each of these items. Give six reasons why such variances might arise and state briefly what corrective action might be taken in respect of each.

I2.2 From the following information calculate labour rate and efficiency, and material usage and price variances:

Standards Wage rate per hour Hours per unit Material used

Actual results Wages paid Hours worked Material used Material cost Number of units produced

O.SOp 4 hrs. 2lbs. per unit@ 0.75p per lb.

£2,520 5,600 I ,900 lbs.

£I ,750 I,OOO

·12.3 At the end of the second year, Planning Ltd had the following results. These were compared with the budget and differences were established. On investigation of cost both budgeted and actual quantities of material and hours worked were established.

Budget 20 units Actual 20 units

Materials Frames I,408 70 cu.ft. I ,538 75 cu.ft. Cladding 3,036 6 ,000 sq .ft. 2,936 5,900 sq.ft. Paint 308 ISO gal. 4I8 I26 gal.

4,752 4,892 Labour

Framing 1,530 3,000 hrs. I ,680 3,IOO hrs. Cladding 9IS 2,700 hrs. 805 2,400 hrs. Spray shop 225 225 hrs. 305 200 hrs.

2,670 2,790 Factory Overhead 8,120 8,730

£I5,542 £I6,4I2 ---

Calculate the variances and discuss possible reasons and relationships between them.


12.4 A company prepared the following budgeted statement for a period:

Sales 40,000 units at £20 each Cost of Goods Sold:

Labour 200,000 hrs.@ £1 Materials 80,000 lbs @ £3 Variable Overhead

(55p per labour hour) Fixed Overhead

(25p per labour hour)

Gross Profit

The actual results for the period were:

Sales 38,000 units at £21 each Cost of Goods Sold:

Labour 180,000 hrs. @ £1.025 Materials 79,000 lbs@ £2.90 Variable Overheads Fixed Overheads

Gross Profit

200,000 240,000

110,000

50,000

184,500 229,100 102,000 48,500

Prepare a Statement reconciling the budgeted and actual profits.

800,000

600,000

£200,000

798,000

564,100

£233,900

CHAPTER 13

Marginal Costing

This is a method of costing which assumes, in the first place, that the difference, or margin, between direct costs and selling price is not profit but a contribution to the overheads and when these have been met the margin represented by any balance of sales is the contribution to profit. The system recognises the following principles:

(l) Direct expenses are calculated on a unit basis and will vary in total according to output.

(2) Selling price is also calculated on a unit basis; revenue will vary in total according to the volume of sales.

(3) The margin, or contribution, will remain static per unit, but will vary in total according to changes in volume.

(4) Overheads cannot be apportioned to units accurately, and where a variety of products is involved there is no known method of charging each product with an equitable portion of the overheads. Overheads tend to remain constant irrespective of output levels.

(5) Direct expenses can be avoided, i.e. if no production no direct costs but if no production no revenue, therefore no contribution to overheads. The elimination of a product results in the remaining products having to bear a larger portion of the overheads.

(6) If direct costs increase, the selling price must be similarly increased to obtain same total contribution. If the selling price cannot be increased then the volume must be increased. Similarly if the selling price has to be reduced direct costs must also be saved or volume increased.

The system enables management to know the levels of sales required for given levels of overhead and profit.

Operation of method

Unit cost ZOO units 250 units 750units 2000 units Material 4 400 1,000 3,000 8,000 Labour 2 200 _2QQ 1,500 4,000 Direct costs 6 600 1,500 4,500 12,000 Selling price 10 1,000 2,500 7,500 20,000 Margin or contribution £440% £400 £1,000 £3,000 £8,000


At all levels of sales, unit costs are £6 each and the contribution is 40% of revenue.

If overheads in total are £5,000 then output required will be:

Overheads £5 ,000 Contribution per unit £4

= 1 ,250 units

At this level profit will not have been earned; only overheads will be covered The point in sales of 1,250 units is referred to as the 'Break-even Point', i.e. the point at which neither a profit has been earned nor a loss incurred.

Profit will accrue from the sale of 1,251 units onwards. If 2,000 units are sold profit will be £3,000 (750 units@ £4).

Total revenue and costs:

1,250 units 2,000 units

Sales@ £10 12,500 20,000 Materials @ £4 5,000 8,000 Labour@ £2 2,500 7,500 4,000 12,000

Contribution 5,000 8,000 Fixed Overheads 5,000 5,000

Profit Nil £3,000

The contributions percentage may also be used to ascertain total sales revenue required to meet fixed overheads and a desired level of profit. For example,

Overheads Profit required Total contribution

required

8,480 16,000

£24,480

£16,000 represents an expected return of 10% on the capital employed in the business of £160,000

If the total requirement represents 40% of sales revenue then this must be

£24,480 X 100 = £6! 200 40 '

and if the company decides on a selling price of £12 a total output of 5,100 units (£61 ,200/12) will be required.

If a selling price of £10 must be maintained output must be 6,120 (£61 ,200/10) at which break-even point will be £8,480/£4 = 2,120 units. Selling price can be fixed after giving consideration to production capacity as well as demand at particular prices.

Marginal Costing 31 7

Calculations at a selling price of £10 would be:

2,120 units 6,120 units

Sales@ £10 21,200 61,200 Materials @ £4 8,480 24,480 Labour @£2 4,240 12,240

12,720 36,720

Contribution 8,480 24,480 Overheads 8,480 8,480

Profit Nil £16,000

Profit is represented by 4,000 units@ £4 each. If material costs increase 15% and labour costs rise 30% whilst a contribution

of 40% of selling price is still required, the price must be raised to £12, i.e.

Materials £4 + 15% Labour £2 + 30%

Contribution two-thirds

Selling price

4.60 2.60

7.20 4.80

£12.00

Contribution @ 40% of selling price is two-thirds of cost

Break-even point is now:

Overheads £8,480 Contribution £4.80

= 1 ,767 unit,s

whilst an output of 5,100 units will be required to earn the desired profit, i.e.

Overheads and Profit £24,480 = 5,100 units

Contribution per unit £4.80

The lower break-even point and reduced output for required profit has arisen by virtue of the increased contribution per unit. If selling price is increased and a desired percentage contribution of selling price is required this gives rise to a greater contribution per unit. The effect of increasing selling price may well be to reduce sales. It will therefore be important to reach break-even point at an earlier stage in output.

If, after the increases in costs, the selling price is not increased, the position will be

Material Labour

Selling price

Contribution

4.60 2.60

7.20 10.00

£2.80

Contribution is now only 28% Break-even point will be: Overheads £8 ,480 = 3 029 units

Contribution £2.80 '

whilst to obtain a profit of £16,000 output must reach 8,743 units (£8,480 + £16,000/£2.80) and though the company may have a demand for the output, lack of facilities may prevent this figure being attained.


The key factor may be shortage of materials or labour or an inability to raise capital for additional plant.

In addition to changes in direct costs and selling price - the latter being adjusted to obtain the same unit contribution - there may also be increases in fixed costs. These wUI require higher levels of output to offset the increased overhead. A change in fixed overhead has no effect on contribution - this is only affected by changes in direct cost and selling price. Present position:

Material 4.60 If the fixed overheads are increased Labour 2.60 from £8,480 to £10,080, the break-

7.20 even point will be

Selling price 10.00 £10,080 = 3,600 units £2.80

Contribution £2.80

If this level of output cannot be attained, an alternative will be to raise the selling price in order to earn a higher contribution per unit. If this is raised to £10.35 the contribution is £3.15 and the break-even point wUI be:

Overheads Contribution

£10,080 = 3 200 "t £3.1S , um s

"The following example shows the effect of changes in direct costs and fixed overheads: Present position:

Sales ( 60,000 units@ £45)

Materials @ £18 Labour 9 Direct

1,080,000 540,000

Expenses 5.40 324,000

Contribution

Fixed Overheads

Profit

2,700,000

1,944,000 756,000

226,800

£529,200

Present contribution is 28% of selling price: £18 + £9 + £5.40 = £32.40 Selling price £45.00 :. Contribution = £12.60 Break-even point is

Overheads £226,800 = 18 000 '

Contribution £12.60 units

The following changes will take place: material increase 10%; labour increase 10%; direct expenses increase lOp per unit.

Twelve salesmen at present on fixed contracts of £6,000 per annum wUl be paid a commission of 80p per unit and their contracts reduced to £1 ,500 per annum. Other economies wUI result in savings of £18,000. The company is unable to increase its selling price but wishes to earn the same level of profit as in the previous year.

Position will be:

Materials £18 + 10% Labour £9 + 1 0% Direct expenses 5.40 +lOp Commission

Selling price

Contribution

Fixed Overheads Less Saving on Salaries

12@ £6,000 72,000 - 12@£1,500 18,000 Other savings --

Future fixed overheads Profit required Total contribution

required

Future results:

Sales@ £45 Materials @ £19.80 Labour @ £9.90 Direct Expenses £5.50 Commission 80p

Contribution Overheads

Profit

Notes:

54,000 18,000

19.80 9.90 5.50

___!ill 36.00 45.00

£9.00

226,800

-- 72,000 154,800 529,200

£684,000

Marginal Costing 319

The contribution is now only 20% of selling price due to increased variable cost and change from fixed cost to variable cost for sales commission

The contribution required is 20% of revenue, therefore the revenue must be: £684,000 X }QQ% = £ 3,42Q,QQQ

20%

at £45 per unit = 76,000 units

Break-even point will be: Overheads £154,800 = 1 7,200 units

Contribution £9

76,000 units

1,504,800 752,400 418,000

60,800

3,420,000

2,736,000

684,000 154,800

£529,200

(1) Output shows a 26.6% increase to obtain same profit. (2) Break-even point will be reached slightly earlier due to transfer of fixed

costs to variable costs. (3) Greater output required to meet profit level due to lower unit contribu

tion. (4) Salesmen's earnings under the previous scheme were £72,000. As a result

of the change in method of remuneration they will earn £78,800:

Fixed Salary 18 ,000 Commission 76,000@ 80p 60,800


They were, however, only required to sell 67,500 units to maintain their previous earnings.

Original fixed salary New fixed salary

72,000 18,000

Commission to be earned £54,000@ 80p = 67,500 units the break-even point for sales staff. They were required to increase sales by 12~% merely to maintain earnings.

(5) The margin of output between total of 76,000 units and break-even point of 17,200 units is an improvement on the original margin of 60,000 units to 18,000 units. A larger fall in output can be sustained before break-even point is reached and fixed overheads not covered. This margin is referred to as the 'Margin of Safety'.

Marginal costing may also be used where two or more products are produced and, as a result of charging overheads by one of the arbitrary methods, one of the products appears to be incurring a loss or earning less profit, as a percentage of selling price, than other products.

The system is concerned with the margin between direct costs and selling price and the latter may have been fixed, taking into account what the market will bear or the company's inability to raise its price as a result of government intervention. The selling price thus bears no relationship to the manner in which the product was costed or the manner of overheads charged.

Similarly, product costs should be examined from the point of view of the contribution that each of the direct costs makes in order that when there is a shortage of material or labour, production can be concentrated on those commodities which give the greatest contribution in relation to the scarce commodity.

Product A B c Units sold 50,000 40,000 25,000 Hours per unit 3~ 5~ 8

Cost Total per unit

Material 12p 6,000 lOp 4,000 20p 5,000 15,000 Labour SOp 25,000 37p 14,800 3.20 80,000 119,800 Variable

expenses 25p 12,500 20p 8,000 1.00 25,000 45,500 Fixed expenses 70p 35,000 1.10 44,000 1.60 40,000 119,000

1.57 78,500 1.77 70,800 6.00 150,000 299,300 Selling price 2.40 120,000 1.75 70,000 7.20 180,000 370,000

Profit (Loss) 83 £41,500 (0.2) £(800) 1.20 £30,000 £70,700

% 34.6 16%

Overheads have been charged on the basis of:

Estimated expenditure Estimated hours


£119,000 -595 ,000 - 20p per hour

If the above information is presented in marginal costing form the position is:

Material Labour Variable Overhead

Sales

Contribution

Fixed Overheads

Profit

A 6,000

25,000 12,500

43,500 120,000

£76,500

Contribution % of Selling Price 63%

B 4,000

14,800 8,000

26,800 70,000

£43,200

61%

c 5,000

80,000 25,000

110,000 180,000

£70,000 189,700

119,000

£70,700

38.8

Product B is incurring an apparent loss as a result of time taken in conjunction with total output and selling price and is therefore bearing a higher charge for overheads. Product B gives a higher contribution than product C due to lower direct costs in relation to selling price. Production should be concentrated on product A, with product B given next priority; any other capacity is used for product C.

If a decision is to be made to cut back on product B the point must be made that a contribution of £43,200 towards fixed costs and profits will be lost. The position will be:

Contribution Product A Contribution Product C

Fixed Overheads

Profit

76,500 70,000

146,500 119,000

£27,500

The direct costs of product B have been avoided but at the same time contribution has been lost.

Although the order of greatest contribution is products A, C, B other key factors may have to be considered, such as material and labour availability together with time required. The total contribution per unit should be considered as a ratio of key factors.


Contribution on material and labour basis:

Product A Selling Price 2.40

Material 12p Labour SOp Variable Overheads 25p

87

Contribution per unit 1.53

per £1 of material £12.75 per £1 of labour £ 3.06

B 1.75

lOp 37p 20p

67

1.08

£10.8 £ 2.92

20p 3.20 1.00

c 7.20

4.40

2.80

£14 £ .875

If material is in short supply production should be concentrated on product C followed by A. If labour is the key factor then priority must be given to product A followed by B.

Comparison between Marginal costing and Absorption costing

Marginal costing ignores fixed overheads as part of production costs; they are a charge against the contribution and considered as expenses for the year in which they are incurred.

Absorption costing charges estimated fixed overheads against estimated production. Each unit bears a portion of the fixed costs. If a unit is not sold the cost is carried forward in the stock valuation; expenses are only charged against revenue in the year in which the sale arises.

The profit may differ depending on costing method adopted and the resulting stock valuation:

Sales 20,000 units@ Variable costs Fixed Overheads Production

Marginal costing

Break-even point is: Fixed Costs £600,000 = 25 000 Contribution £24 u~its (40- £16)

A loss on 5,000 units not sold at a contribution of £24,£120,000 will arise.

£40 £16 £600,000 30,000 units

Absorption costing

No break-even calculation Fixed overheads apportioned on basis of:

Fixed Costs £600,000 £20 . . -------"-- = per umt Production 30,000 Costs are: Variable 16

Fixed _1Q

£36


Sales 20,000@ £40 800,000 Sales 20,000@ £40 800,000 Variable costs@ £16 320,000 Cost of Sales

Contribution 480,000 20,000@ £36 720,000 Fixed costs 600,000

Loss £120,000 Profit £80,000

The closing stock of 10,000 units includes, under absorption costing, fixed costs of £20 per unit, £200,000 in total, the difference between loss and profit.

Under marginal costing, if unit production exceeds unit sales profit is reduced. Similarly if unit sales exceed unit production profit increases because total overhead is charged against total revenue.

Under absorption costing, if unit production is greater than unit sales profit increases, whilst if unit production is less than sales profit reduces because overheads are allocated to units produced and are charged against revenue only when units sold.

Year 1 Production 1 7,000 units Sales 14,000 units Year 2 Production 14,000 units Selling price £50 Fixed overheads

Sales 16,000 units £215,000 Factory 170,000,

Material £13 Labour £15 Factory Variable Overheads £2 Selling Variable Overheads £3

Year 1: Production 17,000 units

Marginal costing

Material@ £13 Labour@ £15 Factory Variable@ £2 Selling Variable@ £3

Less Closing Stock 3,000@ £33

Cost of Sales Sales 14,000@ £50

Contribution Fixed Overheads

Profit

£33

No fixed costs carried forward in stocks.

221,000 255,000 34,000 51,000

£561,000

99,000

462,000 700,000

£238,000 215,000

£23,000

Selling 45,000

Absorption costing

Material 221,000 Labour 255,000 Factory Variable 34,000 Selling Variable 51,000

£561,000 Factory Fixed Overheads 170,000

@£10 731,000

Closing Stock 3,000@ £43 129,000

Factory Costs 602,000 Selling Fixed Overheads 45,000

647,000 Sales 700,000

Profit £53,000

Closing stock includes £30,000 of fixed overheads: 3,000 units@ £10


Year 2: Production 14,000 units

Opening Stock 99,000 Variable costs@ £33 462,000

561,000 Closing Stock

1,000@ £33 33,000

528,000 Sales 16,000@ £50 800,000

Contribution 272,000 Fixed Costs 215,000

Profit £57,000

Opening Stock Variable costs@ £33 Fixed costs@ £10

Closing Stock 1,000@ £43

Selling Fixed Overheads Fixed cost under recovered

Sales

Profit

Difference in opening stock Year 2 30,000 greater Difference in closing stock Year 2 10,000 greater

Difference in profit Year 2 £20,000

In the two years profit under marginal costing is In the two years profit under absorption costing

Difference is represented by closing stock of 1,000 units valued at £10

129,000 462,000 140,000

731,000

43,000

688,000 45,000 30,000

763,000 800,000

£37,000

95,000 105,000

£10,000

In view of the under-recovery the fixed cost rate should have been £15.30, giving an increased stock value.

If variable selling costs are not considered part of manufacturing cost the value of closing stock is reduced accordingly but this would have no effect on the final profit.

Where a system of marginal costing is in operation, a firm preparing a tender will have to consider the extent to which the fixed overheads and profit have been met prior to accepting any further orders.

Two identical companies are preparing a sales quotation for 5,000 units based on:

Maximum capacity

Company A

25,000 units

CompanyB

25,000 units

Present sales@ £10 per unit 10,000 units 20,000 units Variable costs £6 per unit Contribution £4 Fixed Overheads 35,000 35,000 Required profit 15,000 15,000

Contribution required £50,000 £50,000 Break-even point for both companies was 12,500 units (£50,000/£4).


At the present level of sales company A has earned a total contribution of £40,000 (IO,OOO units@ £4) compared with a required contribution of £50,000.

It will therefore have to quote a price of £8:

Variable cost Contribution £IO,OOO

5,000 units

£6

£2

£8

Company B, however, has already earned a contribution of £80,000 (20,000 units @ £4) compared with £50,000 required. It will therefore only need to quote a price sufficient to cover the variable costs, £6.

Company A will be able to accept orders for a further I 0,000 units and any quantity of additional sales will enable them to reduce the price.

Company B now having reached maximum production will have to consider, before accepting further orders, the capital requirements of purchasing additional plant and the additional overheads which will be incurred, e.g. rent of warehouse, etc., which may increase in a greater ratio than to revenue.

Questions

I3.1 The following is the summarised Trading Account of Stores Ltd for the year ended 3I September:

Stocks I Oct. at cost Purchases

Stocks 3I Sept. at cost

Cost of Sales Gross profit

Variable Expenses Fixed Expenses Net Profit

35,000 375,000

4IO,OOO 30,000

380,000 220,000

600,000

35,000 I25,000 60,000

£220,000

Sales

Gross profit

600,000

600,000

220,000

£220,000

Mr Blare, the Managing Director of Stores Ltd, informs you that he expects the Fixed Expenses to increase by I 0% during the following year and asks you which is the better method of avoiding a drop in the net profit, i.e. either (i) by maintaining the volume of sales with a 2~% increase in selling price or (ii) by maintaining the selling price with a 5% increase in volume.

Assuming that the variable expenses will alter only in relation to sales volume you are required to show the effect of each of these two suggested procedures, in the form of estimated Trading Accounts.


13.2 Present the following information to show clearly to management: (I) the marginal product cost and the contribution per unit, (2) the total contribution and profits resulting from each of the following sales mixtures.

Product £per unit

Direct Materials A Direct Materials B Direct Wages A Direct Wages B Fixed Expenses (variable expenses are allotted to products as I 00% of direct wages) Sales Price A Sales Price B Sales Mixtures:

(a) 100 units of product A and 200 of B (b) 150 units of product A and 150 of B (c) 200 units of product A and 100 of B

£800

10 9 3 2

20 15

13.3 Two businesses, A.B. Ltd and C.D. Ltd, sell the same type of product in the same type of market. Their budgeted Profit and Loss Accounts for the year ended 30 June, are as follows:

A.B. Ltd CD. Ltd

Sales 150,000 150,000 Less: Variable Costs 120,000 100,000

Fixed Costs 15,000 135,000 35,000 135,000

Net Profit budgeted £15,000 £15,000

You are required to: (a) calculate the break-even points of each business; (b) calculate the contribution ratio of each business; (c) calculate the sales volume at which each of the businesses will earn £5,000 profit; and (d) state which business is likely to earn greater profits in conditions of (i) heavy demand for the product and (ii) low demand for the product.


13.4 The following is the summarised trading account of a manufacturing firm which makes two products.

Product 2 Total

Sales 10,000 4,000 14,000 Less Cost of Sales: Direct Costs:

Labour 3,000 1,000 Materials 1,500 4,500 1,000 2,000 6,500

5,500 2,000 7,500 Indirect Costs

Variable Expenses 2,000 1,000 3,000

3,500 1,000 4,500 Fixed Expenses 1,250 1,250 2,500 -- --

Net Profit/(Loss) £2,250 (£250) £2,000

The following proposals have been made by the board of directors for your consideration as financial adviser: (1) discontinue product 2; (2) as an alternative to (1) reduce the price of product 2 by 20% (it is estimated that the demand will then increase by 50 per cent); (3) double the price of product 1 (it is estimated that this will reduce the demand by three-fifths).

You are required to write a report to the board evaluating each of these three proposals and give your recommendations; include in your report computations which clearly show the effect of carrying out each proposal.

13.5 The A.B. Engineering Co. manufactures a single product which is sold through approved dealers.

The standard cost of the product is as follows:

Direct Material 9 Direct Labour 7 Variable factory

overhead 4 Variable selling

overhead 2

Production capacity is 60,000 per annum and market research suggests that this quantity could be sold.

Fixed costs have been budgeted for the forthcoming year as follows: Production 80,100 Selling and Administration 63,300

A recent wage award is expected to increase the direct labour cost by 5% and to have a reflected effect in direct material and variable factory overhead costs of 2%. These increased costs have not been incorporated into the standard costs given above.


The company's fixed assets consist of:

Land and Buildings Plant and Equipment Fixtures and Fittings

135,000 125,000 40,000

and it is estimated that other capital employed, in the form of current assets, amounts to £10 per unit sold.

The company expects a return on capital employed of 20% before tax. You are required to calculate the list selling price of the product, which will

cover a dealership discount of 20% on list price and enable the company to achieve its profit objective.

CHAPTER 14

Published Accounts of limited Companies

Section 148 of the Companies Act 1948 requires that every limited company shall present the shareholders with the Profit and Loss Account and Balance Sheet of the fum. Section 149 and that the accounts should give a true and fair view of the state of the company and of its profits. The exact minimum requirements of the Act are set out in the Second Schedule of the Companies Act 1967. In addition to the legal requirements the accountancy bodies have issued several statements of standard accounting practice which, although they have no legal standing, must be complied with.

The purpose of the legislation and the accounting standards is to present shareholders, creditors and potential investors with a basic minimum and consistent standard of information on the business. Many companies give more information than is legally required as they consider this to be of benefit to interested parties.

Every limited company has to file a copy of its annual accounts with the Registrar of Companies within 42 days of the Annual General Meeting. These accounts are available for inspection by any interested person.

Tables 14.1 - 14.3 set out the main publication details which must be shown in the accounts of a company not requiring consolidated accounts.

Published requirement of the Profit and Loss Account 1967 Act

Auditors' Remuneration

Comparative Figures giving corresponding figures for the immediately preceding financial year for all items.

Table 14.1

Reference Schedule 2

Para. 13

Para. 14(5) and Sees 10& 11

Comments

This should include expenses but not costs of other services, e.g. tax work or book-keeping.

Where a change in accounting layout or procedures has taken place it will be necessary to make similar amendments to the previous year's figures.


Published requirement of Reference Comments the Profit and Loss Schedule 2 Account 1967 Act

Depreciation (a) Aggregate amount Para. 12(1)(a) No detailed breakdown into

charged in the classes of assets depreciated period. need be shown.

(b) The method of pro-viding it if other than by an annual charge based on the value of the assets.

(c) The fact that it Para. 14(2) has not been pro-vided for.

Directors' Emoluments (a) The aggregate 1948 Act

amounts distin- Sec. 196 guishing between

(i) fees as directors, (ii) other emoluments,

(iii) pensions, (iv) compensation for

loss of office. (b) Chairman's emolu- Sec. 6(l)(a) For the period of office in

ments. the financial year. (c) The number of direc- Sec. 6(1 )(b) Applicable only to duties sub-

tors in each band of stantially performed in U.K. £2,500 salary.

(d) The emoluments of Sec. 6(2) Exemption from disclosure is the highest paid given where the aggregate director if this is paid to directors is under greater than the £15,000. (Sec. 6(6) covers emoluments of the points (b) -(e).) Chairman.

(e) The total emolu- Sec. 7 ments waived and the number of directors involved.

Dividends The aggregate amount of Para. 12(1)(h) The Directors' Report will dividends paid and show the rate per share. proposed.


Employees The number earning over £10,000 shown in bands of £2,500.

Exceptional Items Details of material amounts caused by (a) Changes in

accounting basis.

(b) Exceptional nonrecurrent transactions.

(c) Amounts arising from previous year's occurrences where not included elsewhere.

Hire Charges Amounts charged for the hire of plant and machinery - where material.

Interest Payable The amounts payable on (a) Bank loans and over

drafts. (b) Loans repayable with·

in 5 years. (i) by instalments,

(ii) other than by instalments.

(c) Loans repayable after 5 years.

Published Accounts of Limited Companies 331

Reference Comments Schedule 2

Sec. 8 U.K. employees only.

Para. 14(6) These items would not normally be incurred in the usual course of the business, e.g. Gains/Losses on Sale of Fixed Assets Gains/Losses on Currency changes

Para. 12A Gains/Losses on Investments, S.S.A.P. 6 gives details of the method of presentations. Particularly such items as adjustments for alterations in previously created taxation provisions or losses arising through previous events, e.g. fines or foreign government sequestrations.

Para. 12(1Xgb) This charge can be compared with the depreciation charge borne by companies owning their plant and is an indication of capital investment policy.

Para. 12(1 )(b) Debenture interest will be shown under (c) until such time as the repayment date falls within 5 years when it will appear under (b).



Investment Income The amount of income Para. 12(1 )(g) These details are usually from shown in conjunction with (a) Quoted investments. the Balance Sheet disclosures (b) Unquoted invest- on Investments.

ments.

Rent Receivable The net income from Para. 12(1 Xga) This is a similar item to the rent, where this is a turnover of a trading com-substantial part of the pany. company's income.

Reserves - Transfers (a) Amounts provided Para. 12(1 )(d) The substance of these para-

for the redemption graphs, together with those of relating to the Balance Sheet,

(i) Share Capital, results in all movements on (ii) Loans any reserve being shown. (b) Amounts trans- Para. 12(1)(e)

ferred to and from reserve.

(c) Amounts trans- Para. 12(1 )(f) ferred to and from provisions which have not been used for the specific purpose for which they were set aside.

Taxation The amount provided Para. 12(1)(c) S.S.A.P. 6 give details of the for UK Corporation Tax treatment of the Advanced showing Corporation Tax system. (a) The basis of the cal- Para. 14(3)

culation which nor-mally would include the rate used.

(b) The amount of Para. 12(1)(c) overseas taxation on profits and capital gains.


(c) Provision for future taxation.

Any special circumstances which affect the charge in the financial year or which will affect it in succeeding financial years.

Turnover The amount and method of calculation

Publication of items on the Balance Sheet

Assets Analysed between fixed, current and neither ftxed nor current.

Fixed

(a) Aggregate amount of additions and dis-posals during the year.

(b) Division of land between

(i) Freehold,



Para. 14(3a)

Para. 13A

Table 14.2

Reference Schedule 2 1967 Act

Para. 4(2)

Para. 11(6B)

Para. 11(6c)

Comments

This refers to the difference between capital allowances and depreciation (normally referred to as Deferred Taxation).

This should only cover external sales of a company and if in excess of £250,000.

Comments



(ii) Long Leases, (iii) Short Leases.

(c) The methods used to arrive at the amount for each type of asset.

(d) Where a valuation is used

(i) the year and amount (ii) the name and quali

fication of valuer where valuation carried out in the year under review.

Current (a) The method of

calculating the value of Stock or Work in Progress.

(b) Whether, in the opinion of the directors, the market value is less than the amounts at which they are stated.

(c) Amounts ofloans made during the year to any officer of the company and the amounts outstanding at the year end.

(d) Amount of outstanding.loans for purchase of company's own shares by employees.

Neither Current nor Fixed Goodwill, etc

The amount not yet written off.


Paras. 4(3) and 5

Para. 11 (6A)

Para. 11(8B)

Para. 11(7) Para. 6(b)

1948 Act Sees. 197 and 190

Para. 8(1Xc)

Para 8(1 )(b)

Comments

A long lease is one which has 50 years' life from the Balance Sheet date. Usually cost less depreciation charged to date. Usually only necessary on Freehold property but can apply to any Fixed Assets.

Usually the lower of cost or net realisable value.

Would include trade debtors and Hire Purchase debtors after provision for bad debts and unrealised profits.

It should be remembered that it is illegal for a company to lend money to its directors unless it represents any advances on account of expenses. A director is an officer of the company.

This includes Goodwill, Patents and trade marks, Preliminary Expenses, Discounts on Debenture, Shares issue costs (Para 3).


Investments

Aggregate amounts of quoted and unquoted investments, respectively. Aggregate market value of quoted investments

The directors' valuation of unquoted investments.

Capital Expenditure

(1) The amount of expenditure for which contracts have been placed.

(2) The amount of expenditure authorised but for which contracts have not been signed.

Contingent Liabilities The type and amount of these which have not been provided for in the accounts.

Cu"ency The basis on which foreign currencies have been converted into sterling.



Para. 8(1)(a)

Para. 11 (8)

Para. S(SA)

Para. 11(6)

Para. 11(5)

Para. 11(9)

Comments

Where different from Stock Exchange value the Stock Exchange value must be shown. Where the directors do not give a valuation details of (a) Income received from

Investments. (b) Share of aggregate profit (c) Share of accumulated

profits. (d) Details of the treatment

of losses in the company's accounts.

This shows the amount the company is liable to meet.

This shows the amount which may possibly be cancelled.

A contingent liability is a liability which cannot be exactly determined and is contingent on the happening of some event outside the control of the company, e.g. the outcome of a legal case or the amount of costs on servicing guarantees.


Published requirement of Reference Comments the Profit and Loss Schedule2 Account 1967 Act

Co"esponding Figures For any item shown on Para. 11(11) the Balance Sheet or and Sees 10 notes. &11.

Dividends The amount recom- Para. 8(1)(e) Also shown on the Profit mended for distribution and Loss Account. as dividend. Amounts of arrears of Para. 11(3) cumulative dividends and the period the arrears cover.

Liabilities Loans

(a) Aggregate amount of Para. 8(1 )(d) Bank Loans and Over· drafts.

(b) Loans repayable by Details.of the terms of lump sum after 5 repayment and interest rates years from the have to be given. Where Balance Sheet date. liabilities are secured on the

(C) Loans repayable by assets this must be stated; the instalments, last assets charged need not be

instalment due after specified. (Para. 9)

5 years from date of the Balance Sheet.

Nominal amount of Para. 10 debentures issued but held by company nominees. Details of Para. 2D any debenture which the company has power to reissue. Details of other liabi- Para. 2 No details of the exact classi-lities. fication of current liabilities

is legally required.

Reserves and Provisions Aggregate amounts of Para. 6 A provision is created for reserves and provisions specific purposes, whereas a Amounts of Share Para. 2(c) reserve is a non-specific. Premium. It is usual for companies to

specify the various reserves.


All movements in reserves and provisions.

Share Capital Summary of authorised and issued share capital. Details of terms and dates of Redeemable Preference Shares. Details of any share option scheme

Taxation Amounts provided for undue fluctuations in charges in Taxation.

Directors Report

Amounts shown in this report which could have been shown in the accounts must have corresponding figures.

Activities

The principal activities and any changes thereto.

Assets Details of significant changes.

Capital and Loans Details of new issue of shares or debentures and how the funds were applied.



Para. 7

Para. 2

Para. 2(a)

Para. 11(2)

Para. 7A

Table 14.3

1967 Act

Sec. 22

Sec. 16(1)

Sec. 16(1a)

Sec. 16(1)8

Comments

It is usual to specify the number and nominal value of each class of share. These must include earliest and latest date of redemption.

Often referred to as Tax Equalisation or Deferred Taxation. Detailed presentation is covered by S.S.A.P.8.

Comments

In working a question on Published Accounts include as many of the requirements in the accounts as possible.

!his should also be seen on rhe Balance Sheet notes, e.g. Fixed Assets disposals.

This would include the amounts received on each class issued.



Directors The names of the direc- Sec. 16(1) tors who held office at any time during the period. Details of option Sec. 16(1)D schemes by which they can obtain shares or debentures in the company or any other company. Details of interest in Sec. 16(1)(e) shares and debentures in the company to include movements in the year.

Dividends The amount expressed on a pence per share basis.

Donations Sec. 19 Political and charitable Where the total exceeds £50 details of amounts and it must be divided between the recipient of political charitable and political. donations. Aggregate Political donations in excess amount of charitable of £50 must specify recipient. donations.

Employees The average number Sec. 18 employed and their aggregate remuneration where the number employed exceeds 100.

Export The value of goods ex- Sec. 20 Only necessary where turn-ported. If Nil, a note over exceeds £250,000. to that effect.

Investments Sec.4 Where a company holds 10% of the nominal value of a class of share or holds 10% of the total capital of another company, the name, place of incorporation, class and proportion of shares held of that company must be stated.


Results Details of the recommended dividend and transfers to reserves. Any other matters which affect the state of affairs of the company where this would not be harmful to company.

Turnover By class of activity and the proportion of profit attributable to each class of business. The contribution of each class of business to the total profits for the period.



Sec. 157{1) {1948 Act)

Sec. 16{1)F

Sec. 17{1)

Comments

A summary of the Profit and Loss Account is generally included under this heading.

Only necessary where turnover exceeds £250,000.

Company requirements where consolidated accounts are required

There are several areas of further information which are required when a company is publishing consolidated accounts. Consolidated sets of accounts should include the total figures of the group for items mentioned earlier, e.g. hire of plant, fixed assets, depreciation. The main areas of difference are the following:

{1) Directors' Emoluments. Details of directors not employed by the holding company need not be shown- Sec. 196.

(2) Group Profit. The consolidated Profit and Loss Account must show the proportion of the total profit attributable to subsidiaries -Sec. 149 {5Bii).

(3) Investments. A Holding Company must disclose the name, country of incorporation and the proportion of each class of shares held in the subsidiary and whether these are held directly or by other subsidiaries- Sec. 3.

Where the company is itself a subsidiary the name of its ultimate holding company and its country of incorporation - Sec. 5.

Where consolidated accounts are not being presented the following additional information is required:

(a) The amount of shares in and other amounts owing from the subsidiary; also the amounts owing to fellow subsidiary companies- Para. 15.2.

(b) A subsidiary must show the aggregate amount owing to and by the parent company- Para. 16.


(c) Reasons why the subsidiary has not been consolidated- Para.l5(4). (d) The aggregate amount of profits in the subsidiary attributable to the

parent company and the holding company's treatment of the amount - Para. 15(4).

In addition to the legal requirements for company accounts and the provisions of the accounting bodies, the Stock Exchange also lays down conditions which a company requiring a quotation for its shares must comply with. The main items affecting accounts are:

(I) Notification to the Stock Exchange of Board Meetings at which dividends or profits are to be declared, and notification to the Stock Exchange of preliminary profit announcements and dividends.

(2) Material acquisitions and disposals of assets. (3) Any changes in the directorate. (4) Reasons for not providing accounts within six months of the end of the

financial year. (5) Details of the following must be provided:

(a) a half-yearly report on the state of the business and the results at least 6 months before the Annual General Meeting which should include earnings per share.

(b) Reasons for adopting alternative methods of accounting if not in accordance with standard accounting practice.

(c) The geographical analysis of turnover and profit contribution of operations outside the UK.

(d) Particulars of agreements under which directors waive fees and shareholders waive dividends.

(e) A statement of results for the previous ten years is normally included.


B. Ltd has an authorised capital of £800,000 divided into 200,000 6% cumulative preference shares of £1 each and 600,000 ordinary shares of £1 each. The company's trial balance at 31 December 19-1 was as follows:

6% Cumulative Preference Shares of £1 each Ordinary Shares issued and fully paid Share Premium Account General Reserve Profit and Loss Account, balance 1 Jan. 19-1 5% 1st Mortgage Debenture Stock

(Interest payable 30 June and 31 Dec.) Creditors and accrued liabilities Dividends from unquoted Investments Dividends from quoted Investments Corporation Tax (Payable 1 Jan. 19-2) Stocks Works-in-Progress Debenture Issue Expenses Trade Debtors Payments in advance Unquoted Investments at cost Quoted Investments at cost Balance at Bank Cash in Hand Freehold Property at Cost Leasehold Property at Cost Plant and Machinery at Cost Dividend on 6% Cumulative Preference Shares

(Paid 31 Dec. 19-1) Interim dividend of 4% on Ordinary Shares (Paid 31 Oct. 19-1)

Trading Profit for Year Progress payments against Work in Progress Provision for bad and doubtful debts Depreciation: Leasehold Property

Plant and Machinery

You are informed that:

200,000 400,000

20,000 90,000 25,500

101,000 46,166

2,750 1,250

35,000 81,642

225,323 2,450

186,957 9,400

52,524 18,242 31,850 2,123

320,000 81,260

277,600

12,000

16,000 186,000 64,320

6,145 29,435

109,805

£1,317,371 £1,317,371

The turnover for the 12 months ended December 19-1 was £1,436,220.


The Trading Profit for the year is arrived at after charging:

Debenture Interest Directors' Salaries Directors' Fees Managing Director's Salary Maintenance of Buildings and Plant Rent and Rates Superannuation contributions for non-directors Hire of Plant Interest on Bank Overdraft

5,050 15,600 2,400

15,000 22,640 14,220 11,500 3,200

346

The figure for directors' fees and salaries includes the emolument of the chairman £2,600, 2 directors' emoluments amounting to £5,200 each and 2 others £2,500 each.

The following provisions are to be made:

(a) Auditors' remuneration (including £150 for expenses)

(b) Depreciation: Leasehold Property Plant and Machinery

(c) Additional provision for doubtful debts (d) Corporation Tax on 19-1 profits@ 50%

(payable 1 Jan. 19-3) (e) Against a loss on an uncompleted contract the

cost of which is included in work-in-progress. (f) Transfer to Debenture Redemption Fund

1,350 7,925

26,220 625

69,000

3,000 19,000

The directors have decided to recommend a final dividend of 7% and an appropriation of £10,000 to general reserve.

In the 19-0 accounts, corporation tax had been underestimated, resulting in an under-provision of £15,000 that year.

Debenture issue expenses are to be written off against the Share Premium Account.

By an extraordinary resolution dated 1 October 19-1 the company issued 50,000 ordinary shares of £1 each, fully paid by capitalising the reserves.

The company had purchased plant and machinery at a cost of £40,000. Cost of plant sold was £30,000, the accumulated depreciation amounting to £29,900. Revenue from sale £300. The profit has been dealt with in arriving at the figure for trading profit in the Trial Balance.

The market value of the quoted investments at 31 December 19-1 was £19,210 and the directors valued the unquoted investments at £56,498 at that date.

The directors had authorised capital expenditure totalling £29,300 of which £9,000 had been placed in the hands of contractors.

Prepare the accounts in a form suitable for publication. Examination questions include items for the published accounts: (a) already

charged against Trading Profits; (b) shown separately on the Trial Balance; (c) In the adjustments still to be incorporated in the Trial Balance.


A preliminary working is necessary to calculate the profit before taxation:

Profit per Trial Balance

Less Auditor's remuneration 1,350

Depreciation Bad debts Loss on WIP

34,145 625

3,000

Add Income from Investments shown on Trial Balance

Profit before tax

186,000

39,120

146,880

4,000

£150,880

The only other adjustments that will be necessary are:

(1) Under-provision for taxation in the previous year (a) Reduce b/fProfit and Loss Account balance. (b) Increase Taxation Creditor {35 ,000 + 15 ,000)

(2) Offsetting items on the Trial Balance Debenture issue expenses (2,450) Share premium 20,000

Per Balance Sheet £17,550

(3) Progress payments against WIP WIP 225,323 Less Progress payments 64,320 Adjustments re loss 3,000 67,320

158,003 Stocks 81,642


(4) Debtors 186,957 Payments in Advance 9,400

196,357 Less Provision 6,145

Adjustment 625 6,770


Balance Sheet adjustments Creditors 46,166 +

1,350

Depreciation Provision 29,435 + 7,925

109,805 + 26,220

Debtors Provision 6145 + 625 625

WIP 225,323-3,000


(5) In order to complete the Fixed Assets Schedule the balance at 1 January is required, i.e.

Figure per Trial Balance Add disposals

Less additions

Balance of 1 Jan.

277,600 30,000

307,600 40,000

£267,600

A similar calculation is required for depreciation. Profit on sale £200 will not be shown in published accounts as it is not considered to be a material figure.

(6) The General Reserve per Trial Balance 90,000 Add Profits capitalised during year. 50,000

Balance at I Jan. £140,000

(7) No adjustment has been made for Advanced Corporation Tax due on the proposed dividend and paid on the interim and preference dividend. The tax due in respect of such dividends will be paid over to Inland Revenue within 3 months of date of dividend payment and subsequently deducted from final Corporation Tax liability.

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 19-1 NOTES:

(1) Turnover £124362220

(2) Profit before taxation 150,880 Less taxation based on the profits

for the year @ 50% 69,000 --

Profit after taxation. 81,880 Unappropriated earnings from

previous years 25,500 Less under provision of Corporation

Tax in previous year 15,000 10,500

Available for distribution 92,380

Dividends Paid 6% Preference 12,000

4% Ordinary Interim 16,000

Proposed 7% Ordinary Final 28,000

56,000 Transfers to Reserve

General 10,000 Debenture 19,000

Redemption 29,000 85,000

Unappropriate earnings 31 Dec. 19-1 £7,380 ---


Notes:

(3) (4)

(5)

(6) (7)

(8)

BALANCE SHEEr AS AT 31 DECEMBER 19-1

Fixed Assets Investments Cu"ent Assets Stocks and Work in Progress Debtors Bank and Cash

Cu"ent Liabilities Taxation 50,000 Creditors 47,516 Proposed Dividend 28,000

Net Cu"ent Assets

Less Corporation Tax due 1 Jan 19-3

Share Capital Reserves Profit and Loss 5% Debenture Stock

239,645 189,587 33,973

463,205

125,516

NOTES TO THE ACCOUNTS (forming part of the accounts):

505,475 70,766

337,689 913,930

69,000 £844,930

600,000 136,550

7,380 101,000

£844,930

(1) Turnover represents the invoiced value of goods sold. There were no exports.

(2) (A) Profit before taxation is after charging:

(B)

Auditors' remuneration Depreciation Directors' Emoluments

Salaries Fees

Interest on Debentures Interest on Bank Overdraft Hire of Plant

After crediting Investment Income (See Note 4)

Directors' Emoluments Chairman Highest paid Director Other Directors

£J)- £2,500 £2,501 -£5,000 £5,001-£7,500

1,350 34,145

30,600 2,400 5,050

346 3,200

2,600 15,000

No. 2

2


(3) Fixed Assets Freehold Long Plant Total Leasehold Machinery

Cost 1 Jan. 19-1 320,000 81,260 267,600 668,860 Additions 40,000 40,000

320,000 81,260 307,600 708,860 Sales 30,000 30,000

Balance 31 Dec 19-1 320,000 81,260 277,600 678,860

Depreciation 1 Jan 19-1 29,435 139,705 169,140 Annual Charge 7,925 26,220 34,145

37,360 165,925 203,285 Eliminate for Disposals 29,900 29,900

Balance 31 Dec 19-1 37,360 136,025 173,385

Net Book Value £320,000 43,900 141,575 505,475

(It is not obligatory to show details of the annual movements on the depreciation provision.)

(4) Investments Income Cost Valuation Source

Quoted 1,250 18,242 19,210 Market Unquoted 2,750 52,524 56,498 Directors

£4,000 £70,766

(5) Stocks and Work-in-Progress are valued at the lower of cost or net realisable value.

( 6) Share Capital

Ordinary £1 6% Cumulative Preference £1

Authorised

600,000 200,000

£800,000

Issued

400,000 200,000

£600,000

During the year, 50,000 £1 ordinary shares were issued to existing shareholders (I for every 7 held) and were settled by a capitalisation of the reserves.


(7) Reserves Share General Debenture Premium redemption

As at 1 Jan. 19-1 20,000 140,000 Capitalisation (50,000) Profit and Loss

appropriation 10,000 19,000 Debenture Issue

expenses written off (2,450)

£17,550 100,000 19,000

(8) 5% Debenture Stock is secured by a floating charge on the Assets and is redeemable on 1 Jan. 19-6.

(9) Capital Expenditure. The directors have authorised capital expenditure of £29,300 of which £9,000 has been placed with contractors.

The following is an example of an internal Manufacturing, Profit and Loss Account from which the information for the published accounts will be extracted:

Cost of Raw Materials Used Sales Sales Salaries (Including Executive Director £12,300) Investment Income Factory Wages Debtors Bad Debt Provision

1,530,550 2,996,800

49,500 42,000

367,200 506,000

5,500

A.C. Ltd, a company which manufactures electronic equipment, has an issued capital of 100,000 6% redeemable preference shares of £1 each and 200,000 ordinary shares of SOp.

The balances on the books at the close of the financial year included the following:

Office Fixtures, at cost Factory Plant, at cost Vehicles, at cost Leasehold Buildings - Factory

Office Advertising Bank Charges Carriage Inwards Loan Interest Office Salaries (Including Executive Director £31 ,000) Plant Repairs (Including Hire Charges £12 ,500) Ughting, Power, Rent, Rates, etc.- Factory

Office

75,000 720,400 34,500

160,000 80,000 13,560

1,430 4,670

30,000 104,000

15,150 40,610 52,200


Selling and Distribution Expenses Directors' Fees (Includes Chairman £25,000

2 Directors at £4,000 1 Director at £12,000)

Profit and Loss Account - at commencement of year Stocks ofWIP (at commencement)

(at end) Stocks of Finished Goods - at commencement

at end Works Management salaries (Including Works Director £18,000)

The following matters have not been dealt with: Depreciation: Plant 5%

Fixtures 1 5% Vehicles 25% Leases over 40 years.

Increase Bad Debt Provision to 2% of Debtors Audit Fee to be provided £6,000 Corporation Tax liability is estimated at £250,000

14,950 45,000

86,520 23,460 25,490 17,840 14,220 28,000

£200,000 is to be transferred to Plant Replacement Reserve and £130,000 to General Reserve.

The following dividends are to be provided for: Preference for year Ordinary @ 12*-% for year Loan interest includes £4,000 on Bank Overdraft and charge in respect of

10% £260,000 Secured Loan Stock payable 31 Dec. 1974. Investment Income represents the dividend on shares in an unquoted

company and interest of £16,875 on 6*% Surrey County Council stock.

Workings

Plant Lease Fittings Vehicle Leaseholds

Depreciation

36,020 4,000

11,250 8,625 2,000

£61,895

Directors' emoluments

Executive Director Executive Director Directors' Fees Work Director

31,000 12,300 45,000 18,000

£106,300

Manufacturing Trading and Profit and Loss Account A. C. Ltd [or the year ending ..

Sales Raw Materials Used Carriage Inwards Factory Wages Plant Repairs Factory, Light, Rent, etc. Works Management Salaries Plant Depn. Factory Lease Amortisation

Carried forward

1,530,550 4,670

367,200 15,150 40,610 28,000 36,020 4,000.

2,026,200

2,996,800

2,996,800


Brought forward 2,026,200 2,996,800 Work in Progress Start 23,460

End 25,490 2,030

Costs of Goods Produced 2,024,170 Finished Goods Start 17,840

End 14,220 3,620

Cost of Goods sold 2,027,790

Gross Profit 969,010

Office Expenses Office Salaries 104,000 Office, Rent, Light, etc. 52,200 Fittings Depn. 11,250 Bad Debts 4,620

172,070 Selling Expenses Sales Salaries 49,500 Selling and Distr. Expenses 14,950 Advetising 13,560 Vehicle Depn. 8,625

86,635 Admin. Charges Leasehold Depn. 2,000 Directors Fees 45,000 Loan Interest 30,000 Bank Charges 1,430 Audit Fee 6,000

84,430 343,135

625,875 Investment Income 42,000

Net Profit 667,875 Taxation 250,000 Transfer to Reserves

Plant Replacement 200,000 General 130,000

Preference Dividend 6,000 Ordinary Dividend 12,500

598,500

Balance for Year 69,375 Balance b/f 86,520

Balance c/f £155,895


Profit and Loss Account for the year ended . ..

Turnover

Profit before taxation After charging

Depreciation Loan Interest Bank Interest Audit fee Hire of equipment

(Note 1) Director's Emoluments

After crediting Income Unquoted Investments Income Quoted Investments

61,895 26,000 4,000 6,000

12,500 106,300

25,125 16,875

Corporation Tax based on the profits for the year at -%

Profits after taxation Appropriations

Dividends: Ordinary Preference

Transfers to Reserves

Balance from previous year

Unappropriated earnings

Note 1 (Directors' Emoluments):

Chairman Highest paid director

£0-£2,500 £2,501 -£5,000 £5,001-£7,500 £7,501 -£10,000 £10,001 -£12,500 £12,501-£15,000 £15,001 -£17,500 £17,501 - £18,000

etc.

Corporation Tax

12,500 6,000

330,000

£25,000 £31,000

No.

2

£2,996,800

667,875

250,000

417,875

348,500

69,375 86,520

£155,895

Corporation tax is a tax on a limited company's profits. The tax is payable 9 months after the end of the financial year or on 1 January of the year following the year of assessment for a company trading before 1965. The tax assessment year runs from 1 April to 31 March. Corporation tax would be payable:


Companies established after 31 March 1965

Financial year end Tax payable Credit period

A 31 Dec. -1 1 Oct -2 9 months

B C 31 March -2 5 April -2 1 Jan -3 6 Jan -3 9 months 9 months

Companies established before 31 March 1965

Financial year Tax year Tax payable Credit period

A 31 Dec -1 -1/-2 1 Jan -3 12 months

B 31 March -2 -1/-2 1 Jan -3 9 months

c 5 April-2 -2/-3 1 Jan -4 21 months

It is possible for a company to have more than one amount of corporation tax outstanding at the end of a financial year. For a company which has 21 months' credit it may be possible to have 3 years' tax outstanding.

Balance Sheet date 5 April -4

Outstanding Corporation tax due 1 January -4 on profits year ended 5 April -2.

This is an overdue debt and would be included in the creditors. The reason for it not being paid may be because the exact amount has not yet been agreed with the Inland Revenue.

Corporation tax due I January -5 on profits year ended 5 April -3. Tax on the previous year's profits.

Corporation tax due 1 Janury -6 on profits year ended 5 April -4. An estimate of the amount due on the company's profits which will probably need adjusting when agreement is reached with the Inland Revenue.

Tax is also payable when a dividend is paid to shareholders. This amount is an advance payment of the corporation tax and is normally deducted from the next corporation tax payment.

Corporation tax is calculated on a basis of profits earned but these profits are adjusted for such items as depreciation which is not an allowable expense and is substituted by writing down allowances. There are several other disallowable items such as entertaining UK residents and payments under deed of covenant to charities.

When the accounts are prepared the exact amount of tax may not be known, as the calculations have to be agreed by the Inland Revenue. A provision for the approximate amount will be incorporated in the accounts.

Year 1

Year2

Dr. Profit and Loss Account } Cr. Corporation Tax Account Dr./Cr. Profit and Loss Account } Cr ./Dr. Corporation Tax a/c

Amount calculated

Under/over-provision for taxation in the previous year.


When a company pays dividends it is required to pay a proportion of its corporation tax (Advanced Corporation Tax - ACT) within three months of the dividend payment. When a company receives dividends from UK companies it also receives a tax credit which can be set against tax due on its dividends (Franked Investment Income - FII).

Taxable Profits Year 1 £50,000 Year 2 £60,000

Paid Dividend Year 1 £ 7,000 Year 2 £21,000

Franked Investment Income Year 1 Year 2 £14,000

basic rate 50% payable 30 June basic rate 50% payable 30 June ACT rate 3/7ths paid 31 March ACT rate 3/7ths paid 31 March

received February.

Corporation Tax

Year 1 31 March ACT Balance c/d

3,000 22,000

30 Sept. Profit and Loss a/c 25,000

30 June Cash 30 June ACT Balance c/d

£25,000

22,000 9,000

21,000

£52,000

£25,000

Year2 Balance c/d 22,000 30 Sept.Profit and Loss a/c 30,000

£52,000

Franked Investment Income

Profit and Loss Account 20,000 Year 2

30 June Cash

28 Feb. FII 30 June Cash

Cash

Cash

-- Cash Tax Credit 3/7ths x 14,000

ACT £3,000 Year 1

31 Mar. 3/7ths x 7,000 C.T.

6,000 Year 2 3,000 31 Mar. 3/7ths x 21,000

£9,000

Dividend Account

7,000 Year 1 Profit and Loss Account Year2

14,000 6,000

£3,000 --

9,000

£9,000

7,000

£21,000 Profit and Loss Account £21 ,000


In certain years substantial amounts of plant may be acquired or disposed of and this may affect the corporation tax. To avoid these sudden fluctuations which are not connected with changes in the trading profits, a Deferred Tax Account may be set up. The Profit and Loss Account will be charged with an amount equal to the amount by which the corporation tax has been depressed as a result of exceptional capital allowances and the Deferred Tax Account will be credited. In subsequent years when the corporation tax is higher because the depreciation charge is greater than the Capital Allowances, the Deferred Tax Account will be reduced and the Profit and Loss Account credited with an appropriate amount of tax. This has the effect of equalising the corporation tax charges to bring them into line with the trading profit.

Example of The Calculation of Deferred Taxation

Originating Tax Annual charge/ (reversing) timing rate credit differences

Year 1 Capital allowances 8,000 Depreciation 2,500 5,500 50% 2,750

2,750 Year 2

Tax Rate Adjust. 110 Capital allowances 12,500 Depreciation 5,500 7,000 52% 3,640

12,500 3,750 Year]

Tax Rate Adjust. 125 Capital allowances 4,375 Depreciation 6,500 (2,125) 53% (1,126)

10,375 (I ,001) Year4

Tax Rate Adjust. (207) Capital allowances 7,000 Depreciation 10,000 (3,000) 51% (I ,530)

(I ,737)

£3,762

Year 1 The deferred tax charge of £2,750 represents the amount of tax which will

become payable in subsequent years based on year I Profits. Year2

Because the rate of tax changed it is necessary to adjust the previous deferred tax provision.


Year] The depreciation charge exceeds the allowances. Tax will be payable on the

difference; a transfer is made from the Deferred Tax Account to offset the additional charge.

DEFERRED TAX ACCOUNT

Year 3 Profit and Loss a/c Year 4 Profit and Loss a/c Balance

1,001 1,737 3,762

£6,500

Year I Profit and Loss a/c Year 2 Profit and Loss a/c

2,750 3,750

£6,500

Salient features of Statement of Standard Accounting Practice 8 - Treatment of Corporation Tax

(I) Dividends payable are shown in the Profit and Loss Account at the amount actually paid to shareholders. The full amount of corporation tax is deducted from the profit.

(2) Advanced corporation tax is recovered by set off against corporation tax of the related year in which the distribution is made.

(3) Advanced corporation tax should be written off if it is not likely to be offset within the next accounting period, unless there is a deferred tax account.

(4) Irrecoverable ACT would not normally be treated as an exceptional item.

(5) Income from Franked Investments should be credited to the Profit and Loss Account at the amount received plus the Tax Credit.

(6) The mainstream Corporation Tax due should be shown separately for each year where not shown under the Current Liabilities together with the date of payment.

(7) ACT due on prepared dividends should be shown as a current tax liability.

(8) The following items have to be included in the tax charge in the Profit and Loss Account and shown separately:

Corporation tax specifing the charge and the rate for the year. Transfers to the Deferred Tax Account. Tax attributable to Franked Investment Income Irrecoverable ACT Relief for overseas taxation.

Terminology

Recoverable Advance Corporation Tax: The amount payable on outgoing dividends paid which can be (i) set off against corporation tax liability; (ii) set off against deferred tax account; (iii) recoverable in the next accounting period.

Mainstream Corporation Tax: the amount due to be paid after deducting ACT from the corporation tax.


Franked Investment Income: dividends received from other UK companies paid out of profits subjected to Corporation Tax.

Salient features of Statement of Standard Accounting Practice 11 - Deferred Taxation

(1) Deferred taxation accounts arise as a result of tax allowances for depreciation being materially more than the depreciation charges in the accounts.

(2) In subsequent years when the allowance is less than the charge the provision for deferred taxation is credited to the Profit and Loss Account over the period of the benefit.

(3) When assets are revalued the tax charge on the profit should be dealt with through the Deferred Tax Account.

(4) Deferred Tax Account should be shown separately and described as such. It is not to be included in the Current liabilities.

(5) The transfers between the Deferred Tax Account and the Profit and Loss Account should be shown separately under Taxation.

Terminology

Timing difference: the difference between profits for taxation purposes and profits in the Financial Accounts.

Questions

14.1 The following Trial Balance of Ingram Ltd is provided at 31 May. The company's main activity is the distribution of chemical products.

Ordinary Capital 350,000 Preference Capital 150,000 Profit and Loss Account 1 June 85,000 Goodwill, at cost less written off 70,000 Land and Buildings 220,000 Plant 80,000 Motor Vehicles 55,000 Depreciation Provisions:

Land and Buildings 50,000 Plant 13,400 Vehicles 28,750

Stocks, at cost 193,850 Debtors and Creditors 93,490 76,850 Bank 130,650 Profit for year 75,975 Half-year Preference Dividend (Gross) 6,000 Investment Income 3,915 Investments 39,900 Corporation Tax 55,000

£888,890 £888,890


Authorised capital is £150,000 8% £1 Redeemable preference shares and 700,000 SOp ordinary shares, the preference shares being redeemable between 1 January 19-5 and 30 June 19-8.

The profit for the year is after charging the following items: (1) Bad Debt Provision £950. (2) Audit Fee £1,250. (3) Advertising £10,300. (4) Managing Director's Salary £28,000, Chairman's Salary £32,000 and

three other directors each earning £15,500. (5) The following provisions are to be made:

(a) Depreciation Plant: 5% on cost Buildings: Long Leases- £1,000 Short Leases- £4,000 Vehicles: 30% on cost

(b) Corporation Tax at current rate £33,000. There has been an underprovision on the previous year of £690.

(c) Final Preference Dividend and an Ordinary Dividend of 15%. Land and buildings consist of:

(I) Freeholds, at cost, £100,000, including £20,000 expenditure during the year. (No depreciation to be provided.)

(2) Leaseholds costing £80,000 have 80 years to run and leaseholds costing £40,000 have 10 years to run. Accumulated depreciation is £30,000 and £20,000 respectively.

Investments consist of: (1) 15 ,900 £1 Shares purchased at par, being the total capital of Medics

Ltd, a private company, the directors' valuation being £18,900. (2) 8% Debentures in Doctrine Ltd, with a market value of 98. Contingent Uabilities consist of discounted Bills of Exchange £16,500 and a

claim for injuries suffered by a customer, whilst on the company's premises, in the sum of £1,900.

Capital Expenditure authorised amounts to £98,000 of which sum £69,000 has been contracted for.

Turnover for the year amounted to £1.75 m. You are required to prepare the Profit and Loss Account for the year to 31

May and a Balance Sheet for publication.


14.2 The following is the Trial Balance of Highlands Ud, at 30 September:

Authorised and Issued share capital: 100,000 ordinary shares of £1 each fully paid 100,000

Share Premium Account 5,000 Motor vehicles

at cost 6,250 Provision for depreciation on motor

vehicles (at 20% per annum on cost) to 30 September 2,500

Gross profit on Trading 75,000 Freehold and Leasehold properties 117,650 Investments (at cost) 10,000 Investment income (including rent

receivable) 4,320 Salaries and wages 28,500 Debtors 35,165 Trade creditors 19,480 Bank overdraft 1,265 General expenses 25,200 Directors' Fees 9,000 Provision for depreciation of leasehold

properties to 30 Sept. 30,900 Stock in trade, 30 Sept. (at cost) 18,700 Profit and Loss Account: balance at 12,000

£250,465 £250,465

(I) Salaries and wages (£28,500) includes £4,000 for the salary of Brown, the sales manager, who is a director of the company. The directors' fees (£9,000) are shared between three directors, Smith (the chairman), Jones and Brown, in the proportions one-half, one-third and one-sixth, respectively.

(2) The item Properties (£117 ,650) includes two leaseholds: (i) cost £18,000 on a 60-year lease, 3 years expired, and (ii) cost £80,000 on a 40-year lease, 15 years expired. Depreciation has been provided by the straight-line method. The properties account has also been debited with £19,650 in respect of a freehold property purchased at a cost of £20,000. An amount of £350, deducted on completion of the purchase, represents rent paid by a tenant for three months.

(3) The investments (£10,000) consist of £3,000 8% debentures in a public company (cost £3,000) and shares in a private company. The current market value (Stock Exchange quotation) of the debentures is £3,000. The value of the shares is estimated by the directors to be £6,000, but it has been decided not to write them down in the books.

(4) The investment income (£4,320) includes (i) a full year's debenture interest, (il) £3,650 in respect of rent receivable from the tenant of one of the leasehold properties, and (iii) dividends in respect of the shares in the private company.


(5) General Expenses (£25,200) includes depreciation of fixed assets and £115 interest on bank overdraft.

( 6) Gross Profit is at the uniform rate of 20% of sales. (7) The directors propose to pay a dividend of 10% for the year to 30

September. You are required to prepare a Profit and Loss Account to 30 September and a

Balance Sheet as on that date, for publication.

14.3 Polygums Ltd, a sweet manufacturing company, has ari authorised and issued share capital of £300,000, consisting of 100,000 7% redeemable preference shares of £1 each and 2,000,000 ordinary shares of lOp each, all fully paid.

The company makes up its accounts to 30 June in each year. The following draft accounts were prepared by the book-keeper from the books as at 30 June.

Balance Sheet

Capital Fixed Assets Ordinary shares 200,000 Freehold land and

buildings 95,000

Preference shares 100,000 Plant and Machinery (at cost) 120,000

Share premium 10,000 Less provision for Asset Revaluation c!eprecia tion 30,000 90,000

Reserve 5,000 Motor Vehicles

Profit and Loss Account 70,862 (at cost) 22,400

385,862 Less provision for depreciation 6,400 16,000

Current.Liabilities Goodwill (at cost) 100,000 Creditors and Accruals 58,726 Investments (at cost)

Quoted 15,500

Unquoted 21,000 36,500

Current Assets Stock at cost 26,570

Debtors 57,140

Less prov. for bad debts 1,040 56,100

Cash at Bank 24,41& 107,088

£444,588 £444,588


Balance c/f


Balance b/f

70,862

£70,862

Trading profit for the year Income from Investments

You have received the following relevant information:

22,452 46,470

1,940

£70,862

(1) The trading profit for the year ended 30 June is arrived at before charging depreciation, but after charging the following items:

Chairman's Salary Managing Director's Salary Sales Director's Salary Audit Fee Audit Expenses Accountancy Charges Rent and Rates Bank Overdraft Interest

(2) Adjustments are to be made for: (a) a provision for fees of £1,250 for the chairman;

10,000 11,500 5,400

750 100 125

5,250 1,000

(b) the doubtful debts provision to be adjusted to 5% on outstanding debtors;

(c) Depreciation to be provided for the year on Motor Vehicles at 20% on cost, and on Plant and Machinery at 10% on cost;

(d) a proposed dividend on ordinary shares at the rate of 3%; (e) a proposed dividend on preference shares; (f) Corporation tax is to be provided at SO% on profit to the nearest £500

over.

(3) The freehold land and buildings were revalued during the course of the year by AB Valuers, on an open market basis, from the original cost of £90,000 to £95,000. The resulting reserve was credited to the Asset Revaluation Reserve.

(4) Income from investments (gross) represents £1,340 from unquoted investments which the directors have valued at £23,500, and £600 from quoted investments which have a market value of £15,108.

(5) The turnover of the company for the year amounted to £497,000, being gross sales less trade discounts.

You are required to prepare, in a form suitable for presentation to the members (i) the Company's Profit and Loss Account for the year ended 30 June and (ii) a Balance Sheet as on that date.

The auditor's report, comparative figures and the directors' report are not required.


14.4 DAF Ltd produced the following draft accounts at the end of their financial year (31 May):

Cost of Sales Works Expenses Plant Depreciation Administration Expenses Salaries Sundries Bad Debts Audit Fee Fittings Depreciation Corporation Tax Preference Dividend paid Ordinary Dividend

proposed

Net Profit

Ordinary Capital Preference Capital Creditors Provision for doubtful

debts Profit and Loss a/c Corporation Tax Proposed Dividends General Reserve


351,407 82,293

7,250 42,305 93,500

6,340 2,000 1,250 2,300

15,120 8,000

10,000

621,765 7,435

£629,200

Sales Investment Income

Balance Sheet

125,000 100,000 37,300

4,200 28,750 32,320 10,000 50,000

£387,570

Land and Buildings Fixtures Debtors Cash in Hand Bank Balance Stocks Plant Investments

The following information is provided:

628,000 1,200

£629,200

150,000 30,850 71,300

47 13,893 84,362 22,488 14,630

£387,570

(1) Corporation tax is the estimated amount payable on the profits for the year at 40% due 1 January after allowing for an over-provision of £1,800 in the previous year.

(2) The Profit and Loss Account includes the following salaries:

Works Director Chairman Managing Director Office Manager

£ 7,000 £18,000 £13,200 £12,300.


(3) The preference shares are redeemable on 31 December 1982 at a premium of 2%.

(4) Investments comprise (a) 9% of the capital of NBG Ltd, a private company, cost £7,330 (directors' valuation £7 ,350), and (b) debentures in Ash Ltd, quoted on the London Stock Exchange at £8,000. The latter company had paid the necessary interest at 8%.

(5) During the year a factory had been purchased for £40,000. Fixtures purchased in year cost £3,500. There had been no disposals of or additions to plant in year. Cost of assets was:

Freehold land and buildings Plant and machinery Fixtures

£150,000 45,000 38,000

Plant is depreciated at 20% and Fixtures at 12~%. Freeholds are not depreciated.

You are required to prepare the company's Profit and Loss Account, Balance Sheet and notes in a fonn suitable for presentation to the members.

CHAPTER 15

Interpretation of Accounts

Whether the accountant works in industry or the profession, he will have to report on the results of financial transactions, such reports being for the benefit of shareholders, potential investors and the board of directors.

In order to explain the information he may have to write a descriptive report which will include a discussion of the structure of the business as well as accounting statistics. The objectives of these reports vary according to the interests of the person to whom the report is addressed; he may be writing to a prospective investor about the state of the company and its future potential or he may have to explain to the board of directors why the company is having difficulty in paying its creditors. The report may not be based on Financial Accounts but on budgeting and costing schedules or investment information. In this chapter only Financial Accounts are considered.

Characteristics of the Report

Reports may take several forms, for example a letter from a professional accountant giving advice on investment, an internal company report from the chief accountant to the managing director, or a formal report from a firm of consultants to a board of directors. Whichever type of report is being undertaken there are several structural characteristics which should be understood.

Presentation

The person to whom the report is being presented will have many other activities to attract his attention and it is probable that on receipt of the report it will be read through generally, then at a later date referred to in detail. It is therefore essential that the report is headed in a manner which accurately reflects its contents.

It should also follow some logical sequence of events, for example first giving a brief description of the existing system or history, the present problems and the likely outcome, and then ending with suggestions and recommendations. Each section of the report should be self-contained and clearly headed.

Fullness

Though succinct, a report should be a full examination of the problem and may well go beyond the purely accounting sphere, considering the use of other than

Interpretation of Accounts 363

accounting knowledge. For example, economic conditions, labour relations,

politics and management policy could be dealt with.

Accuracy

All reports should be accurate and verified where possible. Where values have

been given by persons connected with the firm these should, if possible, be veri

fied by third parties. The following are three examples of statements which may

appear in a report: (1) 'The assets are worth £10,000 at least'; (2) 'The vendor

values the asset at £10,000'; (3) 'We are told the asset is worth £10,000'.

Statement (1) is poor as the report should state the authority for the

valuation; statement (2) is better as it states who valued the asset; but statement

(3) is almost dishonest because it implies that the valuation has been provided by

a disinterested party, which may not be the case.

Clarity and Literacy

The use of good English and the exclusion of ambiguities is essential if the

author of the report wishes to be taken seriously. Adopt good plain English

which is in daily use and is understood -not necessarily perfect literary.prose.

Technical jargon should be avoided, as should slang or colloquial expressions.

The effective use of punctuation and paragraphs cannot be overemphasised.

It should be understood that reports ara written for the benefit of the

recipient, not the author, and terms used should therefore be those which are

understood by the reader. For example, if the report is addressed to a person un

familiar with fmance the report should explain the problem in simple terms.

Contents of the report

The contents of the report will entirely depend on the reason for its being

commissioned and will therefore change with the circumstances. However, when

looking at a business the following distinct areas of discussion will appear:

( 1) Profitability

Depending on the reason for the report this topic must be considered from

the viewpoint of (a) the company, and (b) the individual shareholder. The

company will be interested in the level of profitability, its comparison with past

results and future potential. These can be explained by using Gross and Net

Profits as a percentage of Sales and Capital Employed. The shareholder is

interested in profitability as far as his holding is concerned. This can be indicated

by using Net Profit and Dividends as a percentage of Ordinary Capital and the

dividend received in relation to the cost and market value of his share.

(2) Liquidity

This considers the ease with which a company can meet its debts and at the

same time the extent to which credit is allowed to customers. The position is

clarified by considering the relationship of creditors to purchasers, of debtors to

credit sales, and of availability of funds, for example the level of bank overdraft

facilities.


( 3) Capita/Investment

This considers the effect on profitability as a result of changes in Fixed Assets and the extent to which additional capital has been used in the period under review and the effect on future profits.

( 4) Long-Term Finance

This considers the manner in which the company has raised the required funds, the reason why the funds were necessary and the etfect on profitability. The costs of raising the capital and its effect on dividend policy must also be considered.

( 5) Management Policy

Have there been any changes in the management of the business and what overall effect have these changes had on the state of the business?

It must be emphasised that no one topic of the report should be taken in isolation. The various factors are interrelated, for example a large capital investment in Fixed Assets may have an adverse effect on profits until the assets are brought into full production.

It must also be noted that percentages and ratios must be prepared on a consistent basis, that they are only of use as a means of comparison and that no single percentage should be taken in isolation.

Profitability - The Business

This topic is best illustrated by an example:

Operating statements Year 1 % Year2 % £000's £000's

Sales 500 100 700 100 Less Cost of Sales 350 70 420 60 --Gross Profits ISO 30 280 40 Expenses

General Admin. 25 5 98 14 Selling Expnses 20 4 49 7 Directors' Remuner-

ation 10 2 14 2 10% Debenture Interest 15 3 28 4

Depreciation 20 4 21 3

90 210

Net Profit £60 12 £70 10

Capital Employed 350 350


Gross Profit

This is normally expressed as a percentage of sales and is the amount of profit being made from trading. In the illustration it is 30% in year 1 and increases to 40% in year 2. This increase may be due to an increased selling price of goods or reduced cost of sales. Changes in volume will have no effect on gross profit percentages, as the increase in sales is matched by a proportional increase in the cost of sales. For example:

Goods Sold £600; Cost £400; Gross Profit £200; Margin 33~; Increase in volume 100%

Goods Sold £1 ,200; Cost £800; Gross Profit £400; Margin 33 !%.

In the first illustration it can be seen that the increased gross profit was entirely due to a reduction in costs from 70% of selling price in year 1 to 60% in year 2. As a general rule changes in gross profit percentage reflect a change in the structure of trading of the business or the inaccurate valuation of stocks or sales; for example, cash sales not recorded or goods misappropriated.

Net Profit

This, too, is expressed as a percentage of sales but the movement may have no connection with the movement in gross profit percentage because net profit is affected by the various expense items which do not move in proportion to sales; for example, Depreciation, Debenture Interest, Directors' Remuneration.

The illustration shows that the net profit percentage has fallen from 12% to 10% of sales, whilst the gross profit percentage rose from 30% to 40%. To ascertain the reason for this movement it will be necessary to examine every item of expense and consider it as a percentage of sales. Of particular interest in the illustration is the increase in selling expenses from 4% to 7%. This may be due to additional advertising and product promotion or to changes in distribution methods. The increase in general administration expenses from 5% to 14% may be the result of an increase in bad debts arising from the increase in sales.

Additional investigation would be necessary to establish the reason for the increase.

Return on Capital Employed

This percentage is an indication, to shareholders, of the return being earned on the funds invested. It must be considered in conjunction with the use of capital, i.e. the relationship of sales to capital employed and the return on capital in similar businesses. For the purpose of the illustration, capital employed is considered to be the proprietors' interest.

Net Profit Capital employed

Year 1 £60,000 100 £350,000 X -1- =17.15%

Year 2 £70,000 100 x-£350,000 1 = 20%

This indicates a more favourable use of funds, i.e. in year 1 £350,000 was used to generate £500,000 of sales, whilst in year 2 £350,000 was used to


generate £700,000 of sales. The turnover of capital employed could be expressed as follows:

Sales £500,000 = Capital employed £350,000 Net Profit % to Sales Net Profit % to Capital

Employed

Year 1

1.43

12 17.15

Year2

£700,000 = 2 £350,000

10 20

The factor of sales to capital employed multiplied by the net profit to sales percentage will equal the net profit to capital employed. It is possible for a reduction in net profit to sales percentage to be counteracted by a more efficient use of capital. This is shown in the illustration where the use of an equivalent amount of capital generated increased sales in year 2.

'Ihe Individual

The manner in which an individual judges the profitability of an investment is now considered.

Year 1 % £000's

Net Profit for Period 60 100 Less Corporation Tax 24 40

Transfer to Reserves 8 13.3 Dividends Paid 28 46.7

60

Balance Nil

Share Capital £1 Ordinary Shares

Cost per Share

Dividend X

Ordinary capital 100

1

£350 £1.60

Year 1 £28,000 = 8% £350,000 °

Year2 % £000's

70 100 28 40

42 60

70

Nil

£350 Market value £2.00

Year2 £A.2,000 -£350,000 - 12%

It should be noted that in year 1 the shareholder received 46.7% of the available profits, a dividend of 8%, whilst in year 2 he received 60% of the available profit, a dividend of 12%. This is explained by the fact that the dividend rose by 50% (from 28 to 42) whilst profits only rose by 16.6% (from 60 to 70) and therefore the dividend paid in year 2 must have used more of the available profits.


Investment Yield

This represents the dividend expressed as a percentage of the cost or market value. On the basis of one share which cost £1.60 the yield is calculated as

Dividend paid on nominal value of share x 100 = ~ x 100 = 5% Cost per share 160p 1

The yield per share would be 5%. However, if more shares were to be purchased at the current market price of £2.00 the dividend would then be expressed as a potential yield of

Dividend per share ____fu:>_ 100 _ 401:

Market villue 20{fp x -,-- - 10

This return would be compared with shares in similar companies before comment could be made upon their value. It should be noted however that whilst the dividend paid shows an increase from 8% to 12%, the yield shows a reduction of 1% which is due to the increased market price.

Liquidity

This section of the topic will be discussed by considering the following accounts:

Fixed Assets F'hold at Cost Plant Cost

Depreciation

Stock Debtors Deposits

Less Creditors Bank Overdraft

Working Capital

Capital Ordinary Shares 10% Debentures Retained Profits

700 175

Balance Sheet Year 1

£000's

200 700 400

300 --500

500 875 200

1,575

875

700

£1,200

1,000

200 --£1,200

Year 2

£000's

400 1,300

500

800 --1,200

700 1,000

100

1,800

475 725

1,200

600

£1,800

1,000 500 300

--£1,800


Trading and Profit and Loss Account

Year 1 Year 2 £000's £000's

Sales Credit 7,000 4,000 Cash 1,000 3,200

8,000 7,200 Opening Stock 300 500 Purchases 4,200 3,800 Closing Stock (500) (700)

Cost of Sales 4,000 3,600

Gross Profit 4,000 3,600 Expenses 3,830 3,350 Debenture Interest 50 Depreciation 120 100

3,950 3,500 --

Retained Earnings £50 £100 -- --

The company's bank overdraft has risen considerably during the course of year. This may well be due to the increase in debtors, although the company experienced a fall in credit sales. At the same time the company has apparently had to reduce its creditors. Investment in other assets will also have contributed to the change in the bank balance.

The management of the business can be investigated by the use of selected ratios as follows:

CTeditor,yj}),urchases

This will indicate the amount of time taken as credit from suppliers, and can be shown either as a straight ratio or expressed in terms of weeks or months of credit. For example:

Purchases Creditors

Year 1

£4,200 = 6:1 £700

Year2

£3,800 = 8·1 .£47) .

In year 1, 1 /6th of the purchases had not been paid for, in year 2 this proportion had fallen to 1/8th. As the accounts cover a 12-month period the proportion of unpaid purchases can easily be expressed in months, for example:

Ratio Accounting Period Credit Period

Year 1

6:1 12 months 2 months

Year2

8:1 12 months 1* months


Thus the business is settling its outstanding accounts at a faster rate than previously. The Balance Sheets did not show this.

The credit period taken from suppliers should be compared with the credit period allowed to customers.

Debtors/Credit Soles

Cash sales should be excluded from this calculation as these cannot result in outstanding debts:

Credit Sales Debtors

i.e.

Year 1

£7,000 875

8:1

1* mths.

Year2

£4,000 1,000

4:1

3 mths.

The business is extending the period of credit given to customers. The result of the change in the purchase and sales credit periods will be a restriction on available funds. This overlap of credit periods will have to be fmanced, probably by a bank overdraft.

Composition of Creditors and Debtors

Although the terms of credit have been calculated other factors must be borne in mind:

{1) The periods calculated are average only for the whole of creditors and debtors.

{2) The precise age of individual accounts should be known:

Co. A Co.B

Credit Period 3 mths. 3 mths. Debtors: 1 mth. old 2,000 10,000

2 mths. old 8,000 8,000 3 mths. old 10,000 2,000 --

£20,000 £20,000

Company A will anticipate the receipt of £10,000 in the near future while Company B, showing exactly the same credit period and total debtors, can only anticipate the receipt of £2,000 in a similar period.

(3) The importance of an individual debt to the total figure. If, in the second year, debtors of £1 m. represented three months' credit and a single customer owed £* m. this is significant because it represents 1 * mths. sales. A change of policy by this customer on the placing of future orders or its terms of payment could have considerable effect on the future cash position.

Allowance must also be made for economic conditions and the ability of customers to pay; for example in times of trade restraints the facility with which customers can obtain overdrafts may be restricted.


Liquid Assets

The liquidity of a company can also be tested by a comparison between creditors and liquid assets.

Creditors in this context will usually include trade creditors, proposed dividends, current taxation and overdrafts. liquid assets will include those assets readily realisable as cash, which under normal circumstances would be trade debtors and bank balances.

Year 1 Year2

Debtors 875 1,000 Creditors 700 475 Overdraft 175 720

£875 £1,200 -- ---

liquidity ratio 1:1 1:1.2

In year 1 the company was able to meet its immediate cash requirements but did not have a surplus. In year 2 the position has worsened in that the company is unable to meet its creditors from liquid assets; for every £1.20 owed the company only has £1 available.

When considering this ratio the terms and extent under which an overdraft was granted must be borne in mind. If the overdraft is permanent it is unlikely that a request for immediate total repayment would be made, and it should be excluded from the liquidity ratio.

When considering the degree of pressure creditors can apply to a company, unused overdraft facilities should be borne in mind. In the illustration, for example, it may well be that the company is able to call on a further £500 overdraft facilities in· order to settle the creditors.

Stock turnover as an aspect of liquidity concerns the manner in which funds have been applied in the purchase and manufacture of stocks and the rate at which stocks have been used.

The rate of turnover is obtained by comparing stocks to cost· of sales and is expressed in weeks or months of turnover. Where there have been large movements during the course of a year it is advisable to take the average of opening and closing stocks.

Year 1 Year2

Opening Stock 300 500 Closing Stock 500 700 Average Stock 400 600 Cost of Sales 4,000 3,600 Ratio 10:1 6:1 Accounting Period 12 months 12 months :. Period for which stock

held 1·2 months 2 months

These figures show that in the second year stock has turned over at a slower rate. This may be due to a number of factors; for example; (a) a build up of


obsolete stock; (b) a build up of stocks for planned expansion; (c) the loss or contraction of the market - this is particularly probable where there has been a disproportionate rise in finished goods.

Comparison of the rate of turnover of the differing types of stock may reflect changes in the sales markets.

Co. A Co.B

Raw Materials 60,000 5,000 Work in Progress 10,000 15,000 Finished Goods 30,000 80,000

£100,000 £100,000

It is assumed that the companies operate a similar business. Although Company A will have to obtain funds to pay for their raw materials this will be recovered when the goods are sold. Large stocks of raw materials may indicate an expanding business, particularly where finished goods are a small proportion of total stocks.

Company B, however, will require few funds to pay for raw materials. The extent to which finished goods form a large proportion of total stocks may indicate unsaleable products or contraction of markets.

Capital Investment

When a business invests in new fixed assets, in order to expand or modernise, the immediate effect is a reduction in profits due to increased depreciation charges. This will subsequently be offset by increased revenue when the assets are brought into full production. The source of funds from which these assets were purchased should be examined. In the illustration, £500,000 10% debentures were issued while £800,000 was expended on fixed assets; the additional sum (£300,000) must have been provided from working capital and profits.

Long-Term Finance

When a company wants to raise funds it must consider the effect on the capital structure and future profits.

Co.A Co.B

Ordinary Shares 1,000 500 10% Debentures 500 1,000

--£1,500 £1,500

Profit before Debenture Interest 150 150

Available for Odinary Share-holders after Debenture Interest 100 50

Maximum Dividend 10% 10%


Company A will be able to raise a further £500 in debentures and leave profits equivalent to a 5% dividend, whilst the raising of a similar amount by Company B will eliminate available profits. It should also be appreciated that although a company may have sufficient profits to pay additional dividends it may not wish to increase its share capital, as this may involve a loss of control by existing management.

Management Policy

This covers such matters as the effect of changes in management, trading policies and accounting policies. Accounting policies would include such items as deferred revenue expenditure, for example the carrying forward of research and development charges as an item in the Balance Sheet, and a change in calculating profit under hire purchase transactions. Both of these changes may result in increased profits, as (a) expenditure has not been charged against revenue and (b) stock valuations have been adjusted.

Funds Flow

As an additional method of examining the management of the business a statement showing the sources of the company's funds and the manner in which they have been used can be prepared.

The funds of a business are derived from cash and credit transactions. Although the Profit and Loss Account will show one source of funds it will not show the cash generated because it includes items normally considered as expenses but not represented by outflows of cash or credit, for example, the depreciation of fixed assets, although an expense in the Profit and Loss Account is not a payment of cash or a credit transaction in the fmancial period under review. The outflow of funds occurred when the fixed assets were purchased.

In order to prepare a Funds Flow statement it is necessary to compare the Balance Sheets of a business at the conclusion of two consecutive financial periods, and the following items will be of assistance:

Sources of Funds

Introduction of New Capital Increases in Reserves Increases in liabilities Reductions in Assets

Applications of Funds

Reduction of Capital Reduction of Reserves Reduction of Liabilities Increases in Assets

Note: Reserves will include the unappropriated balance on the Profit and Loss Account.


Consider the following illustration:

Balance Sheet

1 Jan. 31 Dec. Source Application Fixed Assets 2,000 2,500 500 Stock 300 350 50 Debtors 1,500 1,050 450 Cash 400 700 300

4,200 4,600 Less Creditors 700 600 100

£3,500 £4,000

Proprietor's Interest Capital 3,000 3,000 Profit or Loss 500 1,000 500

--£3,500 £4,000 £950 £950

The usual question asked is 'why has cash only risen by £300?' The information would be summarised in the following manner:

Sources Profit Earned Reductions in Debtors

Applications Increase in Fixed Assets Increase in Stock Reduction in Creditors

Increase in Cash

Funds Flow Statement

500 450

500 50

100

950

650

£300


Consideration will now be given to the following transactions: (I) sale of assets; (2) depreciation of assets; (3) capital and loan issues; (4) preliminary expenses

Balance Sheet

I Jan. 31 Dec. Sources Application

Plant, Cost 5,000 5,000 Less Depreciation 2,300 3,100 800

2,700 1,900 Investments at cost 200 200 Net Current Assets 2,800 18,800 16,000 Debenture Discount 1,000 1,000 Preliminary Expenses 300 100 200

--£6,000 £21,800

Capital 5,000 15,000 10,000 Share Premium 500 500 Profit and Loss 1,000 I ,300 300 Debentures 5,000 5,000

£6,000 £21,800 £17,000 £17,000

Notes: (I) The share issue carried a premium of 5%, while the debentures were

issued at a discount of 20%. (2) There was a profit on the sale of investments of £500. This had been

credited to the Profit and Loss Account. (3) £200 of the preliminary expenses together with £800 depreciation had

been charged to the Profit and Loss Account. In order to prepare the Funds Flow statement the following preliminary

workings are necessary:

Disposal of Investments

The source of funds only shows the cost of the asset sold, whereas the funds statement must indicate sale proceeds:

Balance b/d (Cost) Profit on Sale

Investments

200 500

£700

:. Cash received on sale 700

£700



Depreciation and preliminary expenses are shown as sources of funds on the initial workings, although no new funds have been introduced. Those items have in fact been charged to the Profit and Loss Account. To this extent the £300 increase in profits is after charging £800 depreciation and £500 preliminary expenses. The funds generated were £1 ,300 (£300 Profit, £800 Depreciation, £200 Preliminary Expenses) but this figure includes the £500 profit earned on sale of investments which is part of the total source of funds (£700) from the sale.

Calculation of Profit

Increase per Balance Sheet 300 Add back Depreciation 800

Preliminary Expenses 200

1,300 Deduct profit on Investment sold 500

Total Funds generated from Operations £800


Sources Increase in Capital (Including premium) Increase in Debentures (deducting discount) Sale of Investments Profit earned from Operations

Applications Increase in Net Current Assets

10,500 4,000

700 800

16,000

16,000

Consideration will now be given to the following transactions: (1) disposlll. of depreciated assets (plant, freehold); (2) revaluation of assets; (3) taxation and dividends.


Balance Sheet

1 Jan. 31 Dec. Sources AppL Fixed Assets

Freehold Land 50,000 80,000 30,000 Plant 20,000 15,000 5,000

Less Depreciation 12,000 11,000 1,000 8,000 4,000

58,000 84,000 Current Assets

Stock 3,000 2,500 500 Debtors 2,800 3,400 600 Bank 4,000 4,000

9,800 5,900 67,800 89,900

Less Current Liabilittes Creditors 3,500 4,200 700 Taxation 2,000 2,400 400 Proposed Dividend 1,000 1,200 200 Overdraft 6,000 6,000

6,500 13,800

£61,300 £76,100 ---Capital 50,000 50,000 Profit and Loss a/c 11,300 26,100 14,800

£61,300 £76,100 £31,600 £31,600

Notes: (1) The freehold was revalued during the year and the capital profit of

£30,000 has been credited to the Profit and Loss Account. (2) Plant costing £5,000 with a net book value of £1 ,000 had been sold for

£800; the loss on sale has been charged to the Profit and Loss Account. (3) The taxation and proposed dividends outstanding at 1 January were

paid during the year.

Preliminary Workings Disposal of Plant

This will involve adjustments for cost, depreciation and profit or loss on disposal.

Balance b/f

Balance b/f

20,000

£20,000

15,000

Plant

Balance c/f :. Cost of Disposal

15,000 5,000

£20,000

Balance c/f Written back on disposal (£5,000- £1 ,000)

Cost


Depn. Res.

11,000 4,000

£15,000

Balance b/f :. Charge to P and L

Balance b/f

Disposal A/C

5,000 Depn. Cash :. Loss on Sale

£5,000

12,000 3,000

£15,000

11,000

4,000 800 200

£5,000

The funds statement will show a source of funds £800 from the disposal of plant. This will be reconciled with the net source of £4,000 shown in the illustration, as follows:

Cash Received Loss on Sale Depreciation charge for year

Net Movement

£800 200

3,000

£4,000

The Profit and Loss Account will be adjusted by adding back the loss on sale and the depreciation charged in the period.

Taxation and Proposed Dividends

The accounts will appear as follows:

Taxation

Cash paid in year Balance c/d

Proposed Dividend

Cash paid Balance c/d

2,000 2,400

£4,400

Balance b/f :. Appropriation Profit

Balance b/d

2,000 2,400

£4,400

2,400

Dividends

1,000 1,200

£2,200

Balance b/d 1,000 :. Appropriation in P. and L.

1,200

£2,200

Balance b/d 1,200


The funds statement will show the tax and dividends paid as an application of funds and the appropriations of profit as a source of funds, which is incorporated in the total funds generated from trading. The Balance Sheet comparison shows the net movement of cash paid and profit appropriation.


The source of profit £14,800 arises after crediting the £30,000 capital profit arising on revaluation. This is not a source of funds, as no additional cash has flowed into the business, and must be eliminated from the calculation of funds generated. The movement on freehold land of £30,000 is not a true application as funds have not flowed out of the business.

Calculation of Profit

Increase per Balance Sheet Add Back: Depreciation

Loss on Sale Taxation Proposed Dividend

Less Capital Profit

:. Loss on Operations


Sources Sale of Plant Reduction in Stock Reduction in Bank and Increase in

Overdraft Increase in Creditors

Applications Increase in Debtors Taxation paid Dividend paid Loss on operations

800 500

10,000 700

600 2,000 1,000 8,400

14,800 3,000

200 2,400 1,200

21,600 30,000

£8,400

12,000

12,000

A Funds Flow statement should provide information as to how the business obtained its funds, how such funds were used during a financial period and the extent, if any, to which third parties have increased their interest in the business.

A business will obtain funds from (1) trading activities; (2) creation of new capital; (3) raising of loans; (4) disposal of obsolete assets; (5) taking of extended credit from suppliers.

Interpretation of Acoounts 379

The funds so obtained will be utilised in (1) repaying Capital and loans; (2) purchasing of fixed assets; (3) cost of investing in subsidiary and associated companies; (4) allowing extended credit to be taken by customers.

Examination of the statement will provide an insight into future trends such as increased depreciation arising from purchase of additional assets, additional interest charges on new loans and the need to obtain overdraft facilities to repay creditors, where the increase has not been matched by at least a corresponding increase in debtors.

A funds statement will not indicate changes in capital structure as a result of the exchange of debentures for shares or the issue of shares for assets other than cash.

Salient features of Statement of Standard Accounting Practice 10

Statements of sources and applications of funds

(1) The Profit and Loss and Balance Sheets do not show the effect of movement in the assets, liabilities and capital in the year, on liquid funds.

(2) Statement shows how operations are fmanced, distinguishing between purchase of fixed assets and changes in working capital.

(3) Movements in fixed assets should be shown gross. Figures in the funds statements should be identifiable with Profit and Loss and Balance Sheets.

(4) The Funds Statement should be part of the audited accounts.

Terminology

Net liquid funds: cash at bank and in hand, less overdrafts. Investments: considered to be current assets.

Statement of Source and Application of Funds

This Year

£'000 £'000 £'000 £'000 Source of Funds

Profit before tax xxxx Adjustment for items not involving the movement of funds: Depreciation XXX

Total Generated from Operations xxxx Funds from Other Sources

Issue of shares for cash XXX

xxxx Less Application of Funds

Dividends paid (XXX) Tax paid (XXX) Purchase of fixed assets (XXX)

(XXXX)

Change in Working Capital XXX

Last Year

£'000

(XXX) (XXX) (XXX)

£'000

XXX

XXX

XXX

XX

XXX

(XXX)

(XX)


Increase/Decrease in Working Capital

Increase in stocks Increase in debtors Increase/ decrease in creditors -excluding taxation and proposed dividends Movement in net liquid funds: Increase (decrease) in: Cash balances (X) Short-term investments XX

XX XXX

XXX

XX (XX)

XXX XX

(XXX)

XX (XX) Change in Working Capital XXX

Questions 15.1

Balance Sheets as at

1 Jan. 31 Dec.

Fixed Assets Cost less Depreciation 120,000 160,000

Current Assets Stock 240,000 260,000 Debtors 160,000 210,000 Cash 40,000 28,000

440,000 498,000 Less Current Liabilities

Creditors 90,000 128,000 Taxation 10,000

100,000

340,000 370,000

£460,000 £530,000

Share Capital 300,000 300,000 Reserves and Undistributed Profits 150,000 170,000 9% Debenture Loan 10,000 60,000

£460,000 £530,000

You are required to (1) provide a Movement of Funds Statement; (2) explain what additional information might be useful and how it would improve the accuracy of the statement.


15.2 Balance Sheets as at

Assets 1 Jan. 31 Dec. Fixed Assets at Cost Less Depreciation

Trade Investments

Current Assets Stock Debtors Cash

Current liabilities Creditors Taxation Dividends

Net Current Assets

Share Capital Reserves

70 120 30

60 15 5

580 260

220

80


Notes:

320 40

360

140

£500

140 260 100

£500

110 140 25

100 20 10

710 310

275

130

400 30

430

145

£575

160 220 195

£575

(1) There was a profit of £20 on the sale of investments which had been credited to the reserves.

(2) There was a stock loss of £60 relating to prior ye.ar written off against the reserves.

(3) Plant costing £50 had been sold at a loss of £5 which was charged to the Profit and Loss Account (NBV £30).

You are required to (1) prepare a movement of Funds Statement; (2) discuss the state of the company - what additional information is required?


15.3 The following Balance Sheets for Basildon Co. were circulated to the board:

Balance Sheet as at

1 Jan. 31 Dec.

Fixed Assets (at cost) 5,000 5,000 Freehold Land and Building Plant 2,000 5,000

7,000 10,000 Less Depreciation 2,600 3,000

--4,400 7,000

Investments (Market value 31 Dec. £750 2,000 2,000

1 Jan. £2,500} 6,400 9,000

Current Assets Stock: Raw Materials 800 1,000

Finished Goods 500 2,500

1,300 3,500 Debtors 3,000 3,500 Balance at Bank 2,200 100

6,500 7,100 Current Liabilities

Creditors 3,000 4,500 Taxation 900 1,800 Proposed Ordinary

and Preference Dividends 500

3,900 6,800

Net Current Assets 2,600 300 -- --£9,000 £9,300

Share Capital Ordinary Shares 4,000 4,000 6% Preference Shares 1,000 Reserves 2,500 1,000 Profit and Loss Account 2,500 3,300

--£9,000 £9,300

Notes: (1} Stocks have been valued at cost on 1 January, whereas at 31 December

they included 20% overhead addition. (2) A contingent liability at 1 January of £1 ,500 was settled during the year

and charged to reserves.


You are asked to write a report to the managing director, who is unfamiliar with accounts, indicating the financial problems that are likely to arise in the near future. The report should include a Funds Flow Statement and suggestions as to the manner in which any problems arising could be overcome.

15.4 The following is the Balance Sheet and Pmfit and Loss Account of Scene Ltd and has been sent to you from a shareholder. He also says that at the Annual General Meeting in January new directors were elected on their promise to pay a dividend and improve the state of the company.

Balance Sheet as at

1 Jan. 31 Dec.

Fixed Assets (cost less Depn.) Fittings 8,000 6,000 Machinery 6,000 7,000 Freehold Land 11,000

Current Assets Stock 10,000 40,000 Debtors 30,000 60,000 Cash 15,000 500

55,000 100,500

80,000 113,500 Less Current Liabilities

Creditors 20,000 12,500 Bank Overdraft 35,000

20,000 47,500

£60,000 £66,000

Share Capital 50,000 Ordinary Shares of £1 each, 50,000 50,000

authorised, issued and fully paid. Reserves 10,000 16,000

£60,000 £66,000



Sales 120,000 240,000 Opening Stock 10,000 10,000 Purchases 80,000 150,000

--90,000 160,000

Less Closing Stock 10,000 40,000

80,000 120,000

Gross Profit 40,000 120,000 Selling Expenses 6,000 12,000 Administration Expenses 16,000 60,000 Directors' Emoluments 10,000 35,000 Depreciation: Fittings 2,000 2,000

Machinery 1,000

35,000 109,000 --Net Profit 5,000 11,000 Less: Dividend Paid 10% 5,000

Transfer to Reserves 5,000 6,000

5,000 11,000

You are required to write a report to Mr Jones, the shareholder, explaining the events of the past year, the present state of the company and suggesting ways it could be improved, drawing reasonable inferences from the figures and information given.

15.5 On 1 January the whole issued share capital of File Ltd a firm of tea importers, was acquired by B.R. and M.D., who became directors of the company in place of the former directors, who retired. In March the company opened a department which hired out catering equipment. The following are the summarised Balance Sheets of the company.


Balance Sheet as at

Freehold Property at Cost Motor Car at Cost Goodwill Stock at Cost 10,840 Debtors 2,000 Bank 6,150

Goods on Hire at Valuation

Less Current Liabilities Creditors 7,620 Overdraft

Issued Share Capital Profit and Loss a/c Debentures

You are given the following particulars:

Sales Income from Hire Expenses Charged in the Profit and Loss a/c Directors' Fees Other Expenses including Depn. Depn. on Equipment on Hire Net Profit per Profit and Loss a/c

I Jan.

4,600

5,000

18,990

28,590

7,620 ---£20,970

12,000 8,970

£20,970

84,000

1,800 12,000

7,200

31 Dec.

8,200 1,290 5,000

12,360 3,000

15,360 25,200

55,050

15,480 12,000

27,480

£27,570

12,000 9,570 6,000

£27,570

80,000 30,400

4,900 13,700 8,400

600

(1) The estimated market value of the freehold properties at 31 December was £11,400.

(2) The debentures are secured by a mortgage on the freehold properties. (3) The bank overdraft limit is £12,000. (4) All expenses, apart from depreciation, are apportioned equally between

the two types of business. (5) The capital cost of goods on hire was £33,600. You are required to provide a report on the position of the company and the

policy of the directors, drawing reasonable inferences from the figures and information given above.


15.6 The following Balance Sheets of a company are provided and you are required to report on the state of the business and to give an opinion as to whether a request for an increase in the overdraft to £35,000 should be granted.

Balance Sheet as at

1 Jan.

Freehold Premises 35,000 Vehicles at Cost Less Depn. 16,000 Stocks 65,200 88,600 Debtors 46,600 60,100

111,800

162,800 Less Current Liabilities

Creditors 50,200 89,000 Taxation 26,700 21,900 Bank Overdraft 3,500 17,000

80,400

£82,400

Capital 61,000 Reserves 21,400

£82,400

The following information is provided: (i) Extract from the Profit and Loss a/c Last yr.

Sales 466,000 Depreciation: Vehicles 9,000 Directors' Remuneration 6,000 Selling prices were increased by 5% on 1 January.

(ii) Stocks were summarised as follows:

1 Jan. 31 Dec.

Cost Market Value Cost Product A 36,300 44,800 43,600

B 28,900 25,600 23,400 c 21,600

£65,200 £71,400 £88,600

(iii) Cost of Sales was: Last year

£323,000

(iv) Net profit before tax last year amounted to £37,800.

31 Dec.

50,000 14,000

148,700

212,700

127,900

£84,800

61,000 23,800

£84,800

This yr.

480,800 3,000

12,000

Market Value 52,000 31,800 10,200

£94,000

This year

£332,600

Flow Charts and Diagrams


Figure A.l Financial accounting

£ 4,000

DEBTORS Bal. 31.12.-2 Sales on Credit 46,000 - - - ... - PLUS CASH SALES- - - -

50,000 47,000 Cash rec'd

Sales Debtors prepaid exps

3,000 500 - - - ....... - - - - - - - -- - - - -

1- Bal. 31.12.-3 £3,500

I I I ~ I

Balance Sheet is a statement of assets and liabilities which equals the proprietors interest in the business. It does not show the value or worth of the finn

·---------------

r-------1 I I I I

I

I .. £

2,600

The Balance Sheet shows the business at one point of time. It does not show how the changes occu"ed which are shown in the income statement

XYZ BALANCE SHEET AS AT

Fixed Assets Buildings Plant Motor Vehicles

Current Assets Stock

+Debtors Cash

Less Creditors

Less Mortgage

Capital Profit

Less Drawings

31.12.-2

Cost Depn. 20,000 7,900 900 3,300 300

31,200 1,200

.--- ·-... 5,000 4,000 6,000

15,000 2,600

CREDITORS Bal. 31.12.-2 Purchases on credit 106,000- ·-- --- + PLUS CASH PURCHASES ... -- - - -- ·

108,600 Cash paid

Purchase Crs. 1 Accrued Exps.

!__Bal. 31.12.-3

108,000

600 500- - - -- -.-- - - - - - - - - - -- - - -- - - -

£1,100

Flow Charts and Dillgrams 389

·------------, 1 RATES I Cash Paid 2,000 1 Prepaid 1.1.-4

+ --------------~+to 31.3.-4 500

NBV 20,000 7,000 3,000

30,000 ------

12,400'

42,400 12,000

30,400

30,000 1,200

31,200 800

£30,400.

Cost Depn. 20,000 -

7,900 1,250 3,300 450

31,200 1,700

t £1~00--·------l

r1---- ---- -<~~--- ------1 I I I

I 31.12. -3 I

I NVB I

20,000 I 6,650 ... ~ 2,850

29,500

I Shows the effects of trading· 1 : for the period ..

I INCOME STATEMENT I FOR THE YEAR ENDED 31.12. -3

,..-1 II

Sales less Opening Stock Purchases

5,000 107,000

146.000 I • I I

f------ ·- -- J I 112,000 1 r Less closing stk. 7,000

I I I I I I

7,000 ---·-3,500 3,000 --

13,500 1,100 --

12,400

41,900 10,000 --31,900

30,000 1,900

31,900 ---

£31,900

"'1 J Cost of Sales I I I I

l J I I .I I I

Gross Profit Wages Rates Electricity General Exps.

105,000

41,000 10,500 1,500<11-----2,000

25,000

I I : I Depreciation

.. 2,000 I

500 -I. NET PROFIT

1 I I II I I I I Profit 31-12.-2 £1,200 I I I Drawings 800 I 1 I I 1 1

Lj i - Acc-;;m~l;t;J Profit; a-re - -I 1 shown on the B./S. I 1

1,500

400 £1,900

Depreciation is not an outflow of fUnds. It is accumulated year by year on B./S.

____ ----- __ -·- __ J L- WAGES Cash Paid Creditor

10,000

~·-, £10,500 I

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Flow Charts and Diagrams 391

Figure A.3 Inputs to a master budget

SALES BUDGET

I I

PRODUCTION BUDGET

I t MATERIAL PLANT LABOUR

REQUltMENT CAP riTY REQUlfMENT

MATERIAL CAPITAL LABOUR PURCHASES-+EXPENDITURE __..._COSTS

OVERHEADS

FACTORY+

ADMIN.+

SELLING+-

,

MASTER BUDGET


Figure A.4 (a)-( e) Information flow diagrams

SYMBOLS D Do<ument•

D Accounts Ledgers

0 Checking verification

File 'T' Temporary 'A' Alphabetical

Document Flow

- - - - - - - ...._. Information Flow

@ Cost control connection

8 Main Ledger connection

Regularly Produced Reports - Monthly

Weekly Yearly

Figure A.4 (b) Wages

WORKS

Records office

WAGES DEPT.

Verification

I I I I I

~ I

Wages record

I I I I I I I I

~ I

8 &

Flow Charts and Diagrams 39 3

CASH OFFICE

Cash requisition

Cash book

R.M

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Figure A.4 (d) Sales system

SALES ORDERS DEBTORS CONTROL

Orders

verification

Invoices

Customers

Flow Charts and Diagrams 395

F.G.STORE CASH OFFICE

to customer with goods

Despatch note

Cash Rec'd. Listings

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Figure A.6 Cost and financial control

INPUT COSTS RECORDS REVENUE

,___P_u_rc_h_a_se_s __ .....Jr - - -

,___w_a_g_e_s ___ ....Jr----COST CONTROL ----1 SALES

,___c_a_sh ____ ....JJ-- --I I I

Creditors

I I I I r-----r-

~--------~- I MAIN LEDGER .....-::::O,.,..,th,-e_r ______ _, _____ j

Appropriations 1

Financial Accountant

Production Director

Works Manager----.

Cost Accountant

Financial Director

I I I I I I I

'Y I I I I I

I

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Annual Accounts

I 1\ I I I I

S~areholdersj Duectors-

---1 ---1

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Directors

Financial and Cost Accountants

I

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Index

Absorption costing 261 Accounts

balancing 31 equation 7, 24, 29 form 24, 29 interpretation 362

Accounting concepts consistency 15 matching 15 principles 29 prudence 15

Accruals 16, 33,35 Accumulated fund 115 Amalgamations

accounts 196 arrangements 194

Assets 10 12

12

changes current definition fixed 12 replacement sale 40

43

Auditor 3

Bad debts 46 Balancesheet 7,8,10,22,65,345 Bonus issues 1 72 Branch accounts 84 Break-even point 316 Budgets

capital expenditure 229 cash 229 committee 225 control 224 definition 224 expenses 228 key factors 226,227, 228, 229,

230

labour utilisation 227 master 230 production 2 2 7 sales 226

Business equity concept 5 funds 5, 10, 127 realisation 136, 191 transactions 8, 9

By-product costs 287

Capacity variance 293 Capital

accounting 146 bonus issues 172 expenditure budget 229 gearing 169 issue expenses 146 issue premiums 14 7 issue underwriting 149 limited companies 144 methods of raising 144 redemption reserve fund 156 repayment 155, 161 rights issue 174 sole trader 13

Company accounts requirements 329 Consolidations

accounting requirements 202, 203

procedure 204 Contribution costing 315 Control

accounts 80 branches 84 creditors 81 debtors 81 hire-purchase 89


Corporation tax 350 Cost: estimate 254 Cost accounting:

distinctions 251, 253 Costing

contract 272 marginal 315 material analysis 266 materials 252 overheads 252 process 268 product 267 standard 291 uses 251

Costs: fixed 316 Creditor 10

Debenture issues 154 Debtor 10 Depreciation

explanation I 9, 3 7 flow of funds I 9, 40 schedule 42, 70

Drawings 10

Efficiency variance 293 Expense budgets 228

Final accounts: - non-trading organisation I I 7

Fixed costs 316 Funds-flow statement 66, 3 72

Goodwill 132,199

Hire-purchase 89

Income and expenditure 115 Income statement 13, 14, 15, 64,

74 Incomplete records

clubs and societies 114 treatment 102

Insurance 36

Job costing method 267 profit-taking 266, 269, 272 variances in estimates 269

Joint product cost 287

Labour costs 292

efficiency variance 293 rate variance 293 utilisation 227

Liabilities current 12 long-term 13

Liquidity 367 Loan repayment 155,161

Machine utilisation budget 237 Manufacturing account 266, 348 Marginal costing 31 5

break-even 316 contribution 315

Master budget 230 Material

budget 228 price variance 292 standards 292 usage variance 29 5

Overheads absorption by products 261 apportionment by department

261 expenditure variance 298 methods of charging 261 recovery rates 262 standards 293 volume variance 293

Partnership Act (I 890) 125 admission of new partner 132 agreement 125 capital 128 current accounts 129 dissolution 136 revaluation 132 types of 124

P.A.Y.E. 33, 34 Prepayments 16,35 Pnze funds 118 Process costing 276

losses in production 276 valuation of W.I.P. 282

Production budget 227 Profit

capitalisation l 72 creation 10, 13 gross 14 net 14

Proprietor's interest 7, 13

Purchases: calculation of 1 09

Quoted companies: Stock Exchange requirements 340

Rates 16,35 Ratios

capital employed 365 dividend yield 367 sales 365

Receipts and payments 114 Reconstructions

accounting 190 law relating to 191 share valuation 193

Rent 16,35 Report-writing 362 Rights issues 175

Sales budget 226 calculation 13 cost of 15, 31 , 59, 11 0 price variance 300 volume variance 301

Share issues 143 premium 147 valuations 173, 175, 178, 202,

257 Single-entry

accounting opening fund profit 103

102 102

Standard costing 291 purposes of 291 terminology 292

Index 403

Statement of Standard Accounting Practice

No. I (Associated Co.) 216 No. 8 (Taxation) 354 No.9 (Stock) 260 No. lO(Fund~ 379 No. 11 (Deferred Tax) 355

Stock record cards 69 valuation 1 7, 25 5

Subscriptions 116

Taxation accounts 350 equalisation 353

Trial balance 50, 62, 75

Underwriting of share issues 149

Variances capacity 293 efficiency 293 labour 293 material 292 mix 311 overhead 293 volume 293 yield 311

Wages 33 Work in progress 268